120

JBIC Review No. 4

May 2001

How the EMS (Electronics Manufacturing Service) Business Model

Can Help Japanese Corporations Revolutionize their Factories? ............................................... 1
Masanobu Kita

Chattel Collateral Laws of Bulgaria,

Rumania and Hungary and Japanese Enterprises’ Business ..................................................... 25
Koji Suzuki

Rural Enterprises Finance : A Case Study of the Bank of Agriculture and

Agricultural Cooperatives (BAAC) in Thailand ......................................................................... 57
Naohiro Kitano

Public Expenditure Management and Developing Countries

Part I: Public Expenditure Management and Development Assistance............................... 72
Kaoru Hayashi

Part II: Case Studies ................................................................................................................. 85

Taichi Sakano
Masashi Aoki

Applied General Equilibrium Analysis of East Asian Growth ................................................... 93

Minoru Ono

HOW THE EMS (ELECTRONICS MANUFACTURING SERVICE)
BUSINESS MODEL CAN HELP JAPANESE CORPORATIONS
REVOLUTIONIZE THEIR FACTORIES?
Masanobu Kita*
SUMMARY
1. EMS (Electronics Manufacturing Service) basically
refers to the consigned production of electronic
equipments. EMS is still not very common in Ja-
pan, which is known for its strong manufacturing
sector, but this type of service continues to attract
attention due to the tremendous success enjoyed
by EMS providers in the United States.
2. With the EMS business model adopts “supply chain
management (SCM)” to increase the speed of op-
erations and reduce inventories, while standardiz-
ing facilities and enacting real-time information
sharing between one’s corporation, customer (brand
manufacturer) and suppliers. Furthermore, the earn-
ings structure in this model is based on low-cost
operations and increased bargaining power in the
procurement of materials and components.
3. Corporations ideally want to develop long-term
relationships with the suppliers of their main com-
ponents, but at the same time they still want to be
able to rigorously select suppliers and alter their
supply routes. EMS is a business targeting prod-
ucts that are difficult to differentiate through the
production process, but even this business model
has limits.
4. When Japanese corporations consider offering con-
signed production services as a means of
revolutionalizing their factories, including those of
overseas affiliates, there are two issues they must
address; namely contextual skills and changing
over to a service provider. First, it would be realis-
tic to start receiving consigned services from other
divisions within a group.
* Economist, Direct Investment Research Division, Research Institute for Development and Finance.
1 ‘Outsourcing’, “Nihon Keizai Shimbun” February 5, 1993, “Nihon Keizai Shimbun” September 6, 1991 Evening Paper, page 5
JBIC Review No. 4 May 2001 pp 1~24
©2001 by Japan Bank for International Cooperation. All rights reserved.
JBIC Review No.4 1
INTRODUCTION
1. FROM OUTSOURCING TO OPEN-
SOURCING
In recent years there has been a qualitative change
among corporations towards greater outsourcing of
production, especially for computer-related prod-
uct.
Outsourcing is seen as “a partial agreement to
participate in carrying out a larger agreement.” In
the case of manufacturing, the contractor consigns
one of the following three duties to a sub-contrac-
tor (supplier): (1) part development and produc-
tion, (2) complete product development and pro-
duction, and (3) provide supplemental technologies,
labor, facilities and skills for specific manufactur-
ing and design process, as well as various other
services (Nishiguchi, 1996).
Eastman Kodak is a well-known example of a
major corporation that has effectively used
outsourcing. In 1989 Kodak entrusted almost all
of its system-related work, from development to
operation and maintenance, to external parties. It
also sold most of its hardware and software to IBM
and DEC. Roughly 350 employees were also trans-
ferred to IBM as Kodak aggressively adopted
outsourcing. The outsourcing contract was valued
at $500 million dollars with a period of 10 years.
The result was that Kodak was able to slash its com-
puter investment by 90% and reduce annual ex-
penses by 10~20%. This success further heightened
2 How the EMS (Electronics Manufacturing Service) Business Model
Can Help Japanese Corporations Revolutionize their Factories?

Figure 1 EMS Supply Chain Management (SCM) Model

Design Maintenance
EMS Procurement Production Services

Brand Manufacturer
Development Product Planning Design Procurement Supplier Final Assembly Sales Maintenance Services

ASIC

General Parts
Cheap Parts
Source: Produced by the author based on an interview with Solectron Japan.

interest in outsourcing in the U.S.1
The market’s taste for computer-related prod-
ucts varies greatly. The functions of these products
have improved greatly, while their lifecycles are
more likely to be shortened.
For example, the lifecycle for personal comput-
ers is said to be only three months and prices can fluc-
tuate wildly. In such an environment the final assem-
bly manufacturers (hereinafter referred to as the brand
manufacturer) need speed to handle these short prod-
uct lifecycles and maintain its competitiveness in the
market. Specifically, corporations in the U.S. and
Europe have been specializing on their core compe-
tencies (core capabilities to provide unique value),
while outsourcing processing and assembly.
These processing and assembly services are of-
ten provided by Electronics Manufacturing Service
providers, also known as EMS providers. EMS pro-
viders differ from conventional OEM (Original Equip-
ment Manufacturing). Original Equipment Manufac-
turers are usually entrusted with just one specific as-
pect of the production process, and so generally pro-
curement of materials and components is handled by
the brand manufacturer. The EMS provider, on the
other hand, is entrusted with everything from design,
trial manufacturing and procurement to production
and, in some cases, after sales services. The EMS pro-
vider is an independent corporation that does not have
its own brand and is not dependent on a single client,
but has a wide range of customers2.
The EMS provider uses the Internet to exchange
order and technical information with its client, the
brand manufacturer, and uses supply chain manage-
ment3 to shorten the lead-time for everything from
procurement of materials and components to produc-
tion, and thus raise the quality and specialization of
the service offered. At the same time, the EMS pro-
vider establishes production and distribution centers
around the world to help lessen the client’s inventory
risks. Another unique characteristic of EMS provid-
ers is that they openly spread their risk by not relying
on only a few select clients, and they try to make or-
dering smoother and optimize production (Deguchi,
1996).
Outsourcing is a means of for obtaining advanced
technologies, low prices and lower risk. However,
brand manufacturers and EMS providers are able to
develop functional relationships through supply chain
management. Global Internet society exchange infor-
mation over the web and create a mechanism for shar-
ing knowledge. Designs for capturing technicians and
customers over the Internet are being improved and
advanced at a rapid pace. This is all part of the quali-
tative shift towards the use of open-sourcing between
corporations (Deguchi, 1996).

2 Hisami Mitarai [Study on Emerging Corporate Groups in the Electronics Industries of Singapore/Malaysia] (Nomura Research
Institute “Nomura Asia and Global Report” January 2000) page 38, “3 Minutes Lesson: Keywords for Managers” (“Nikkei Information
Strategy” August 24, 2000 issue) page 12
3 Method for sharing information along a chain from the supplier to the customer in which the exact amount of parts and products
can be swiftly provided in an exact timing.

2. OUTSOURCED PRODUCTION BY
JAPANESE AFFILIATES IN EUROPE AND
THE U.S. DESPITE STRONG
RESISTANCE IN JAPAN
This EMS business has been developing in Europe
and the U.S. through functional relationships with
brand manufacturers, and this has obviously caught
the attention of Japanese corporations as well. Do-
mestically, Japanese corporations have resisted the
use of EMS on grounds of quality concerns and to
protect jobs. However, some of their overseas affili-
ates have sold factories to EMS providers, and some
have even begun consigning production to these fac-
tories that were previously in their possession. This
consigned production has been for such products as
personal computers, communications equipment, cel-
lular phones, memory modules and car electronics.
Hitachi is one such example of a Japanese cor-
poration consigning production. In 1998, Hitachi
Semiconductor of America (HSA) entrusted the pro-
duction of memory modules to Celestica after deter-
mining that this Canadian EMS provider had the tech-
nologies and production specialties needed for build-
to-order production4.
Fujitsu is an example of a corporation that sold
one of its factories to an EMS provider. In 1997 the
D2D business division of Fujitsu’s ICL (England) was
sold to Celestica. This D2D business division handled
production of personal computers and other on an
OEM basis and had sales of $560 million and 2,500
employees at the time of the purchase. The selling of
this division was part of ICL’s restructuring efforts
aimed at focusing more on its main system develop-
ment and network businesses5.
Mitsubishi Electric is an example of a Japanese
corporation that sold one of its factories and then had
its products produced at that factory on a consigned
basis. In 1998 Mitsubishi Consumer Electronics
America (MCEA) sold its wireless telephone produc-
4 Selestica’s Press Release
5 “Nikkei Sangyo Shimbun”, January 9, 1997, page 9
6 Selectron’s Press Release
7 ‘New Story of Manufacturing in U.S.’, “Asahi Shimbun”, July 25, 2000, Morning Paper
8 Selestica’s Press Release
9 “Nihon Keizai Shimbun”, October 19, 2000, Morning Paper, page 1
10 Document from Technology Forecasters
JBIC Review No.4 3
tion facilities in Georgia to EMS provider Solectron
(US). Solectron employed 350 former MCEA em-
ployees and entered into an agreement to provide
MCEA with a full range of services from trial manu-
facturing, PCB assembly and final assembly of its
cellular products for the North American market6.
In the same manner, NEC sold its North Ameri-
can communications equipment factory in Oregon in
2000 to the NatSteel Electronics, Singaporean EMS
provider, and has since consigned production to this
factory7. NEC also agreed to sell its NEC de Brazil
communications equipment factory to Celestica and
entered into a 5-year supply contract valued at roughly
$1.2 billion. NEC de Brazil is hoping to focus its re-
sources on development, marketing and distribution8.
Domestically, it was learned in October of 2000
that Sony would sell its production affiliate Sony
Nakaniida to Solectron (US), and consign to Solectron
production of its car electronics. This decision was
made after Sony confirmed that Solectron could pro-
vide the same level of quality while reducing pro-
duction costs9.
CHAPTER 1
RAPIDLY GROWING EMS BUSINESS
1. RAPID GROWTH AS BRAND
MANUFACTURERS ABANDON “FULL-
SET” PHILOSOPHY
The EMS market has been expanding at a rapid pace
and further growth is expected in the future. In fact,
the market is expected to expand to around $260
billion (28.1 trillion yen; 108 yen = $1) by 200410.
This would put the annual rate of growth between
1998 and 2004 at 28%. In addition to the rapidly
growing demand for computers, cellular telephones
and other IT-related parts, corporations with an eye
on providing more value to the shareholders have been
4 How the EMS (Electronics Manufacturing Service) Business Model
Can Help Japanese Corporations Revolutionize their Factories?
Figure 2 Forecasted Growth for EMS Market
3,000
2,500
2,000
$100 million
1,500
1,000
500
0
1998 1999 2000
Note: Figures from 2000 are all forecasts
Source: Technology Forecasters
specializing on their core competencies (core ability
to provide unique value) and have been actively
switching to value chains. This is all expected to ac-
celerate the use of outsourcing.
Many factors can be cited for the rapid growth
of the EMS market. The following are a few factors
for U.S. brand manufacturers mainly in the area of
computer-related products.
(1) Due to the progress of parts modulization, corpo-
rations are placing greater emphasis on procur-
ing specialized parts as opposed to working to
make a wide range of parts. Naturally, some of
the value added during the processing and assem-
bly stages is lost.
(2) Device and software technologies are changing
at a rapid pace and product lifecycles are becom-
ing shorter. Therefore, TTM (Time To Market),
TTC (Time To Customer) and other concepts re-
garding the time it takes to bring products to the
markets and customers are very important. Inevi-
tably, the inventories of products and procured
parts have swelled.
(3) Even more effective management of resources is
demanded due to greater emphasis on shareholder
value.
11 Fabrication-less corporations are those that do not own their own production facilities.
12 Toshihiro Yamada, Toru Okamoto “Special Report: Learning from America’s High-tech Industrial Recovery” (“Weekly Toyo
Keizai”) July 17, 1999, page 31
2001 2002 2003 2004 (Year)
Against this changing business environment, the
merits of the “full-set” philosophy that covers all value
chains have been hotly debated. As a result, more
corporations have decided on the outsourcing of
manufacturing processes that can not be considered
as a part of their core competencies. Other decisive
factors in using EMS providers are “the EMS pro-
vider will not only purchase the factory, but may also
employ the existing workers” and “information can
be used by the supply chain management as a tool for
increasing speed”. Thus, it can be analyzed that EMS
quickly started up as a business. The rapidly chang-
ing business environment has led to the aggressive
use of outsourcing and has supported the emergence
of EMS businesses.
In the early 1990’s Cisco Systems began launch-
ing several R&D-type venture businesses like Bay
Networks (currently Nortel Networks). Many of these
corporations were “fabrication-less”11. This means
that the actual production of their products was
outsourced12. We cannot overlook the fact that EMS
providers have served an important incubator role
by providing production infrastructure for many of
Silicon Valley’s high-tech venture corporations.
Data for America’s top 100 listed and publicly
 JBIC Review No.4 5

Figure 3 Ratio of Fixed Assets to Total Assets for Top 100 Companies in U.S. and Japan
(%) U.S. (listed and publicly owned corporations)
75
70 Tangible Fixed Assets
Total Assets
65
60
55
50
45
40
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 (Year)

(%) Japan (listed companies)

75
Tangible Fixed Assets
70
65
Total Assets
60
55
50
45
40
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 (Year)

Remarks: Prepared from Japan Economic Research Institute “Enterprise Financial Data”,
Standard & Poor’s “Compustat”
Source: Cabinet Office “FY2000 Economic Report” (July 2000)

Figure 4 Main EMS Providers (consolidated)

(Unit: million dollars)
Company Name Country Name Sales Net Profit Sales by Region (%) Fiscal Year End
Solectron U.S. 14,138 497 U.S.: 69%, Europe: 20%, Asia: 11% August 2000
SCI Systems U.S. 8,343 197 U.S.: 50%, Overseas: 50% June 2000
Celestica Canada 5,297 67 Canada: 41%, U.S.: 26%, Europe: 20%, Asia: 13% December 1999
Flextronics Singapore 4,307 121 Asia: 16%, The Americas: 40%, Western Europe: 25%, Central Europe: 19% March 2000
Jabil Circuit U.S. 3,558 146 U.S.: 67%, Overseas: 33% August 2000
Sanmina U.S. 1,215 94 n.a. October 1999
Source: Prepared by the author from Market Guide Inc. “The Benchmark for Quality Financial Information”

owned corporations show that while total assets have 2. EMS PROVIDERS BOASTING HIGH
been increasing, the ratio of fixed assets has actually EARNINGS AND PROFIT GROWTH -
been decreasing. This would suggest that big corpo- FROM PCB ASSEMBLY TO FINAL
rations are separating themselves from the produc- PRODUCT ASSEMBLY
tion process and are instead relying more and more The top 6 EMS providers are Solectron (U.S.), SCI
on outsourcing. Systems (U.S.), Celestica (Canada), Flextronics
(Singapore), Jabil Circuit (U.S.) and Sanmina (U.S.).
Solectron, the largest of these corporations, posted
6 How the EMS (Electronics Manufacturing Service) Business Model
Can Help Japanese Corporations Revolutionize their Factories?

Figure 5 Average Annual Growth over Past 5 Years for Top EMS Providers (consolidated)
Solectron SCI Systems Celestica Flextronics Jabil Circuit Sanmina Average for 6 corporations
Sales 46.9％ 25.6％ 16.7％ 71.3％ 44.8％ 60.2％ 44.3％
EPS 31.8％ 27.9％ ▲19.7％ 53.0％ 67.5％ 32.0％ 32.1％

Note: EPS refers to earnings per share.

Source: Prepared by the author from Market Guide Inc. “The Benchmark for Quality Financial Information”

Figure 6 Main Customers Accounting for 10% or More of Sales for Top EMS Providers
1996 1997 1998 1999
Solectron HP ● (11%) ● (14%) ● (14%) ● (11%)
Sun Microsystems ● (11%)
Cisco Systems ● (11%) ● (12%)
Nortel Networks ● (10%)
Celestica IBM ● ●
HP ● ●
Sun Microsystems ● ● ●
Cisco Systems ● ● ●
Source: Solectron’s Annual Report, Selestica’s Annual Report

consolidated sales of $14.1 billion13 (1.53 trillion yen;
108 yen/$) and net profit of 500 million dollars (53.7
billion yen), and its business continues to grow.
The average rate of sales growth for these six
corporations over the past five years was a whopping
44.3%. The rate of growth in per share earnings was
a very high 32.1%, providing further evidence of the
rapid growth achieved by these corporations. A break-
down of sales by region shows that America is the
main market, but these corporations are also aggres-
sively developing business in Europe and Asia. Many
of these corporations have bases in ten or more coun-
tries.
EMS providers target consigned production
mainly of IT-related products such as desktop and
notebook computers, network equipment, communi-
cations equipment and mobile equipment. In recent
years Solectron and SCI Systems have bought facto-
ries from Ericsson and Nokia to aggressively estab-
lish cellular phone production bases. (Solectron is
believed to currently be responsible for 10% of the
world’s cellular phone production14.) Even though
EMS providers have mainly handled PCB assembly,
the ratio of final product assembly has been increas-
ing in recent years. In the case of Solectron the ratio
of finished products to PCB was 5 : 95 in 1995, but
21 : 79 in 1999.15 Operations have also been expanded
to upstream services such as trial manufacturing and
product development, and downstream services such
as distribution and maintenances.
The main customers for Solectron are Hewlett-
Packard (HP) and Cisco Systems, each of which ac-
count for more than 10% of its overall sales. The main
customers for Celestica are Sun Micro Systems and
Cisco Systems. Sun Micro Systems, Cisco Systems
and HP are shared customers of these two leading
EMS providers. A unique feature of EMS providers
is that they try not to rely on just a few select custom-
ers, but are open to receiving work from many differ-
ent corporations. The brand manufactures, likewise,
choose to use several different EMS providers.

13 Compared to a Japanese electronics corporation, Solectron has a business scale a little smaller than Sharp, which has consolidated
sales of around 1.85 trillion yen.
14 Based on an interview by the author with President Yasui, Solectron Japan (November 22, 2000)
15 Solectron’s Annual Report
 JBIC Review No.4 7

Figure 7 Average Profit Margins over Past 5 Years for Top EMS Providers (consolidated)
(Unit: %)
Solectron SCI Systems Celestica Flextronics Jabil Circuit Sanmina Average for 6 corporations
Sales 100 100 100 100 100 100 100
Gross Profit 10.0 3.7 6.5 8.3 11.0 21.5 10.2
Operating Profit 5.7 3.6 2.1 2.5 6.7 13.2 5.6
Net Profit 3.8 2.1 0.6 1.3 4.3 8.4 3.4
Source: Prepared by the author from Market Guide Inc. “The Benchmark for Quality Financial Information”

Figure 8 Average Operational Efficiency over past 5 Years for Top EMS Providers (consolidated)
(Unit:8%)
Solectron SCI Systems Celestica Flextronics Jabil Circuit Sanmina Average for 6 corporations
ROA 8.6 7.1 0.9 2.1 11.6 14.8 7.5
ROI 12.2 11.6 1.1 4.1 19.3 18.6 11.2
ROE 17.4 18.5 2.0 6.9 25.3 30.3 16.7
Note: ROA = net income/average assets, ROI = net income/(average long-term debt and other long-term liabilities,
stocks and assets), ROE = net income/average common stockholders’ equity
Source: Prepared by the author from Market Guide Inc. “The Benchmark for Quality Financial Information”

CHAPTER 2 chain management, had a gross profit rate of 21.4%

FINANCIAL CHARACTERISTICS OF
EMS PROVIDERS
The following is simply a general overview of the
financial conditions for the top six EMS providers.
However, special mention has been made to areas
were there is a significant variance between the cor-
porations.
1. PROCUREMENT OF MATERIALS AND
COMPONENTS AS A SOURCE OF PROFITS
Looking at profit rates based on sales, each corpora-
tion had gross profit rates of 10% or higher. Half of
all corporations have rates under 10%. The difference
between gross profit rates and operating profit rates
are on average 4.6% for these six corporations. In
other words, gross profit rates are around 10%, but
sales expenses and general operating expenses have
been suppressed to a very low 4.6%. By comparison,
the brand manufacturer Dell Computer, which has
successfully reduced inventories by using supply
and an operating profit rate of 9.4%. This means that
sales and general operating expenses were around
12%. In the case of Sony, which sold a production
affiliate to an EMS provider, the gross profit rate was
26%, while the operating profit rate was 5.6%. This
means that sales and general operating expenses were
20.4%. The difference was large sales expenses (fig-
ures are the averages for the past five years accord-
ing to market Guide Inc.).
Looking at the sales breakdown, in the case of
Solectron, which uses a value chain, 80% of sales
were attributed to procurement of materials and com-
ponents16. The remaining 20% was attributed to pro-
cessing and assembly. This is one reason why the sales
expense and general operating expense ratios are so
low. SCI Systems in 1999 procured more than 20.5
billion materials and componets from some 17,500
different suppliers17. Taking this all into consideration,
it would seem that the source of profits for EMS pro-
viders comes more from its large volume purchases
of all-purpose parts, as opposed to its mounting and

16 Based on an interview by the author with President Yasui, Solectron Japan (November 22, 2000)
17 SCI Systems’ Annual Report
8 How the EMS (Electronics Manufacturing Service) Business Model
Can Help Japanese Corporations Revolutionize their Factories?

Figure 9 Cash Flow of Main EMS Providers (consolidated)

(Unit: million dollars)
Solectron SCI Systems Celestica Flextronics Jabil Circuit Sanmina
Cash flow from business activities 38.0 ▲68.0 ▲94.4 ▲67.4 107.3 115.1
Cash flow from ▲819.4 ▲615.8 ▲277.3 ▲572.2 ▲174.3 ▲418.1
investment activities
(▲425.8) (▲280.2) (▲211.8) (▲250.5) (▲150.1) (▲65.3)
Cash flow from financial activities 1,877.2 629.0 711.4 1,069.6 157.4 351.1
Changes in cash on hand 1,100.4 ▲49.3 339.8 424.1 90.4 48.2
Free cash flow ▲387.8 ▲348.2 ▲306.2 ▲317.9 ▲42.8 49.8
Note: Free cash flow refers to the amount after capital investment and dividend payments have been subtracted from
the “cash flow from business activities”.
The figures inside the parentheses ( ) for investment activities refers to capital investment.
The figures for Solectron, Celestica and Jabil Circuit are for 1999. All other figures are for 2000.
Source: Prepared by the author from Market Guide Inc. “The Benchmark for Quality Financial Information”

Figure 10 Efficiency of Main EMS Providers (consolidated)

(Unit: times)
Solectron SCI Systems Celestica Flextronics Jabil Circuit Sanmina Average for 6 corporations
Per Capita Sales ($) 508 263 476 159 543 414 394
Per Capita Net Profit ($) 18 6 8 − 22 19 15
Accounts Receivable Turnover 8.79 11.22 8.82 9.65 9.27 9.04 9.47
Inventory Turnover 5.88 7.51 7.12 7.82 9.10 8.32 7.63
Fixed Assets Turnover 16.31 16.09 18.27 8.56 7.89 6.09 12.20
Average Asset Turnover 1.94 2.90 2.28 2.03 2.55 1.64 2.22
Note: Accounts receivable turnover is sales / average accounts receivable, inventory turnover is cost of goods sold / average
inventory, fixed assets turnover is sales / average fixed assets, and average assets turnover is sales / average assets.
The figures for Solectron, Celestica and Jabil Circuit are for 1999. All other figures are for 2000.
Source: Prepared by the author from Market Guide Inc. “The Benchmark for Quality Financial Information”

assembly businesses. The cost for procurement of
materials and components is not determined solely
on volume, rather information skills, logistics, and
early participation in the design stage are all used to
reduce these costs (Handfield et al, 1999).
2. HIGH EFFICIENCY INDICATED BY 12.2
FIXED ASSET TURNOVER
These EMS providers have maintained very high lev-
els of operational efficiency with average ROE and
ROI coming to 10% or more. However, many of these
providers had minus free cash flows. These corpora-
tions place precedence on investment, putting money
back into purchases and capital investment. There-
fore, it takes time before returns in cash can be seen.
These six corporations had an average accounts
receivable turnover rate of 9.5, an average inventory
turnover rate of 7.6, and an average fixed income turn-
over rate of 12.2. Furthermore, average asset turn-
over rates of 2 or greater have also been achieved. By
comparison, Dell Computer has an average asset turn-
over of 2.5, while the figure is 1.0 for Sony (accord-
ing to Market Guide Inc.).
Looking at fixed assets, it can be seen that
Solectron regularly purchases factories, but direct
capital investments are rare. Typically an investment
bank or other financial institution will first be pur-
chased, and then leases will be arranged through these
institutions18. Reducing assets in this manner while
improving capacity utilization through increasing and

18 Toshihiro Yamada, Toru Okamoto “Special Report: Learning from America’s High-tech Industrial Recovery” [Weekly Toyo
Keizai] July 17, 1999, page 31

smoothing orders is thought to be the main reason
behind these high turnover rates for fixed assets.
(Lease accounting in the U.S. classifies leases as fi-
nance leases and operating leases. With operating
leases, the lease fees are handled as expenses by the
borrower. With finance leases these fees are handled
by the borrower as fixed assets or purchase obliga-
tions.)19
The business structure is one in which assets,
including inventories, are kept as small as possible to
bring about a faster turnaround. Management, for the
most part, is conducted in a very efficient manner.
CHAPTER 3
BETTER COMPETITIVENESS
THROUGH SUPPLY CHAIN
MANAGEMENT
The major EMS providers can propose and make full
use of advanced multi-layer board mounting tech-
niques. Based on this foundation, the EMS provider
can focus on products that are difficult to differenti-
ate through the production process, and can make use
of supply chain management (SCM) while standard-
izing equipment and sharing real-time information
between itself, the customers and the suppliers. SCM
uses this information sharing to increase overall speed
and reduce inventories. Currently only the produc-
tion of desktop computers has advanced to the pure
BTO (build-to-order) stage where there are no inven-
tories20.
1. CONDITIONS FOR FORMING A
BUSINESS: SHORT LIFECYCLES AND
MASS PRODUCTION OF PRODUCT
DIFFICULT TO DIFFERENTIATE IN THE
PRODUCTION STAGE
EMS providers are mainly entrusted with the pro-
duction of personal computers, network equipment
19 “Lease Accounting” (September 1996), Chuo Keizaisha “Practical Affairs of English Financial Statements” supervised by
Asahi Incorporated Accounting Firm
20 Based on an interview by the author with President Yasui, Solectron Japan (November 22, 2000)
21 Fumio Koyano “Conditions for Starting an EMS Business” (Ohm “Electronics” February 2000) pages 2~3.
JBIC Review No.4 9
and cellular phones. In the case of personal com-
puter production, for example, product planning in-
volves combinations with peripherals such as
motherboards, LCDs that already have de facto
standards, and so horizontal specialization is de-
veloped. In order to properly meet the TTM (Time
to Market) and TTC (Time to Customer) require-
ments under short lifecycles, parts with de facto
standards must be quickly procured, assembled and
delivered.
In other words, EMS providers do not provide
production for every type of electronic equipment.
Rather, they must be able to handle products such
as personal computers that have rapidly changing
technologies, short lifecycles and must be made
cheaper, as well as products that are difficult to dif-
ferentiate through the production process21. In other
words, modulization is a necessary condition, and
heavy weighting is given to software, which has
added value, and variable costs for the additional
supply of developed products is low despite the
high development costs (Kokuryo, 1999). These are
the conditions for starting a business. For Ameri-
can brand manufacturers, which are major users of
EMS providers, the rate of returns from their ser-
vices businesses tend to be larger than the rate of
returns for their products businesses (see Figure
11).
2. STANDARDIZATION OF FACILITIES,
PROCUREMENT AND PARTS
DISTRIBUTION
Solectron is a good example of an EMS provider that
has actively standardized its facilities. Solectron ba-
sically introduced the same equipment and assembly
methods for everything from part mounting to inspec-
tion equipment at its 11 mass production trial bases
(NPI centers) and its 57 mass production factories
around the world.
The location for the production of the consigned
10 How the EMS (Electronics Manufacturing Service) Business Model
Can Help Japanese Corporations Revolutionize their Factories?

Figure 11 Product Division and Service Business Earning Rates for Leading American Brand
Manufacturers
(Unit: %)
1997 1998 1999
IBM Gross Profit Rate Product 35.9 31.6 26.9
Service 26.6 26.9 27.6
Operating Profit Product 12.4 7.9 4.9
Rate Service 11.5 13.0 14.1
HP Gross Profit Rate Product 29.8 28.2 29.5
Service 36.9 37.4 31.8
Note: Figures for IMB’s products and services are based on hardware and global service figures
from their segment information.
Source: Prepared by the author from Annual Report of each company

Figure 12 Supply Chain Management (SCM) Configuration

Solectron
Order Forecast Materials &
Brand Main Business Forecast of
System Demand Trends components
Manufacturer
Supplier
Delivery ERP Package SCM Management Delivery
Software
Source: Based on the “Nikkei Information Strategy” (August 1998) page 17 diagram with additions by the author.

products is determined based on the target region
for sales of the product or the nearest factory to the
target region22. A global basic parts procurement team
is organized to facilitate smooth procurement of ma-
terials and components. The members of this team
are those responsible for procuring and managing
materials and components used by the factories in the
various regions. Furthermore, codes in agreement with
standard manufacturing codes are attached to the
materials and components, and customer parts codes
are shared. Standardization is also important in the
distribution of these parts. When a condenser for a
specific purpose is needed at the start of production,
an all-purpose FPGA (Field Programmable Gate Ar-
ray) is used to change the gate array on the board and
set the desired application. There has been a switch
to customize ASIC (Application Specific Integrated
Circuits) based on the notion that the FPGA function
is stable and can be used for a long period of time
(Handfield, et al., 1999). ASIC allows for cheaper
mass-production as compared with FPGA. This is one
example of how all-purpose parts are used in the ini-
tial stage of production.
Jabil Circuit offers a good example of real-time
information sharing. When Cisco Systems entrusted
Jabil Circuit with the production of routers and
switches, it provided Jabil Circuit with the exact or-
der it had received from its customer. After receiving
this order, Jabil Circuit used its supply chain man-
agement to conduct procurement of materials and
components and production, and then delivered the
product directly to the original customer, bypassing
Cisco Systems23. In this manner a mechanism is con-
structed to eliminate the asymmetry of information
(differences in the amount of information held by the
business partners) between business partners.

22 Shoichi Terayama, Ryohei Yamazaki “Trends and Beyond Trends” (“Nikkei Business”, October 30, 2000) pages 8 ~ 9
23 Toshihiro Yamada “Special Edition: Seek Winners of the Internet Revolution”, (“Weekly Toyo Keizai”, May 6, 2000)
pages 68 ~ 69

3. ACTUAL SUPPLY CHAIN MANAGEMENT
APPLICATIONS
The managerial foundation for EMS providers is
based on the supply chain management that incor-
porates the brand manufacturers and the suppliers
of materials and components. Part inventories are
controlled and business efficiency is raised by
timely and efficient production and purchasing
plans. These plans take into consideration demand
forecasts based on customer needs and make ac-
tive use of Internet technologies. EMS providers
can begin production within 24 hours of receiving
the customer’s order.
The following is an actual example of how this
supply chain management was applied by Solectron.
First of all, the following standards were estab-
lished in the supply chain management. These stan-
dards had a huge influence on the selection of suppli-
ers (Handfield et al, 1999).
(1) Very flexible
(2) Ability to handle sudden increase in orders
(3) Main parts supplier can handle 30% increase in
the order
(4) Can forecast demand
(5) Can alter production processes to match product
specifications
(6) Shipping within two weeks
(7) Can reduce by half the period needed from trial
manufacturing to actual production. Can contain
in its production plan the brand manufacturer
making the order, production contents, schedules,
prices and other details in advance. Can obtain
an unofficial notice of the production amount two
to three months before the order is to be placed.
Along with orders from the brand manufacturer,
design data are also received over the Internet. This
provides evidence of the rapid changes in demand
that have huge impacts on the nature of the orders
each month. Production plans are reorganized to meet
these changing orders, but ERP (Enterprise Resource
Planning) is also introduced as a basic business sys-
tem for managing the related profits. Along with the
24 “Dramatic Effects from Providing Information Directly to Customers” (“Nikkei Information Strategy”, August 1998),
pages 16~17.
25 SCI Systems’ Annual Report
JBIC Review No.4 11
real-time management of the progress of orders, pro-
duction, inventories and earnings conditions, the
major brand manufacturers are also provided with a
browser covering the production and delivery of the
ordered products.
In order to maintain suitable inventory levels,
supply chain management software is used to fore-
cast weekly demand trends based on data regarding
past orders. These results are reflected in the produc-
tion plan proposals, the various production line sched-
ules and parts purchasing plans. By carefully manag-
ing the purchasing schedule and understanding the
parts delivery schedule, an accurate delivery sched-
ule can be provided to the brand manufacturer.
Among the more than 7,000 suppliers of materi-
als and components used, forecasts for the next six
months are provided to a little more than 100 of the
main suppliers and updates are provided on a weekly
basis. In the case of printed circuit boards and other
all-purpose parts, deliveries are made within one week
after the order is placed in order to maintain adequate
inventory levels24.
SCI Systems introduced a Supplier Managed In-
ventory (SMI) program, which is a program used to
supplement its suppliers to better handle the large fluc-
tuations in customer orders. With the program the
parts suppliers manage hub- warehouses near the SCI
System’s factories. Hub-warehouses are part of a
mechanism for delivering materials and components
to the factory on a “just-in-time” basis25.
4. SUPPLY CHAIN MANAGEMENT EFFECTS
The calculation of the cash conversion cycle time for
the six leading EMS providers is shown in Figure 13.
The cash conversion cycle time is calculated by add-
ing the number of days for receivable accounts and
the number of days for inventory turnover and then
subtracting the number of days for paying accounts
payable. This serves as an indicator of how quickly
products are converted into cash.
The average cash conversion cycle time for
American corporations that have introduced supply
12 How the EMS (Electronics Manufacturing Service) Business Model
Can Help Japanese Corporations Revolutionize their Factories?
Figure 13 Cash Conversion Cycle Time (consolidated)
Solectron SCI Systems
No. of Days for Receivable Accounts 41.5 32.5
No. of Days for Inventory Turnover 62.1 48.6
No. of Days for Paying Accounts Payable 46.8 41.3
Cash Conversion Cycle Time 56.8 39.8
Source: Prepared by the author from Annual Report of each company
chain management is just under 80 days (just under
30 days at the highest levels)26. The cycle time for
EMS providers is between 35 to 56 days. Without
question, this means that they have achieved a very
high level of performance compared to other busi-
nesses.
CHAPTER 4
BUYING FACTORIES AND
ACCUMULATING STRATEGIC
ASSETS
1. PURCHASES TO ESTABLISH NETWORK
EXTERNALITIES
EMS providers have been purchasing factories from
brand manufactures based on the notion of horizon-
tal specialization. There are many cases in which the
EMS provider will also enter into multi-year contracts
to produce the products the brand manufacturer used
to produce on their own at the factory they sold to the
EMS provider. The scale of the EMS providers is also
growing at a rapid pace. In fact, in October 2000
Solectron, the world’s largest EMS provider, an-
nounced that it had purchased 43% of the existing
shares in NatSteel Electronics (Singapore), the world’s
sixth largest EMS provider27.
It is well known that IT businesses in the U.S.
have been undergoing a structural change from their
perpendicular “full-set” philosophy to a more “hori-
zontal development” approach. This change has been
accelerated due to the advantages being gained by
26 “Results of a Study by U.S. Research Firm PRTM on Businesses Using Supply Chain Management (1997)” (Nikkei Business
“50 Methods for Innovating Business 2000 version”), page 132
27 Solectron’s Press Release
Celestica Flextronics Jabil Circuit Sanmina
41.4 37.8 39.4 40.4
51.3 46.7 40.1 43.9
35.9 49.2 44.0 36.7
56.7 35.3 35.5 47.6
those who have already made these changes. It has
been said that this is due to the functioning of net-
work externalities for the products of the IT businesses
(Kokuryo, 1999). Network externalities means that
the utility values increase when there is use by a larger
number of people. Therefore, greater importance is
being placed on horizontal business development.
Continuous purchases by EMS providers are seen
as having a large impact on network externality. Fur-
thermore, when the factory of a major brand manu-
facturer is purchased, the EMS provider can effec-
tively convince the market that it can guarantee the
same level of quality as the brand manufacturer.
2. FLEXIBLE PRODUCTION FACILITIES TO
HANDLE LARGE ORDER FLUCTUATIONS
A unique characteristic of the EMS providers is that
they do not use the purchased production faculties in
the same manner as the previous owners. Instead they
reorganize the production lines to accommodate
greater standardization. Scale merits are also produced
by adjusting the production methods so that the same
product can be produced anywhere.
The products entrusted to the EMS providers not
only have wildly fluctuating demand, but also have
short lifecycles and provide low gross profit rates
when produced using conventional methods. There
are even some products that can only be produced for
a few weeks. Therefore, the production lines use a
movable wheel and carriage method.
At the Solectron factory in Milpitas production
is temporarily stopped when the number of printers

produced exceeds 30,000. Then the entire production
line is transferred to the plant in Guadalajara Mexico
where cheaper labor can be used. In this manner a
full-production system can be introduced without any
changes to the plans. The Milpitas factory has trial
mass-production functions and joint operations with
designers from the brand manufacturer are conducted
here.
Some production facilities at the Milpitas fac-
tory are also lent to a plastic parts supplier seen as a
strategic partner so that this supplier can produce
printer covers. The main reason for this arrangement
is to cut down on the expenses associated with ship-
ping these printer covers. Workers are also trained to
handle a variety of line operations. This helps to pre-
vent the workers from become bored with repetitive
operations and further improves worker flexibility
(Handfield et al, 1999).
The factories purchased by the EMS providers
are rarely held as their own property, but more com-
monly a leasing arrangement is made. The case men-
tioned earlier where Solectron entered into a leasing
arrangement through a purchased investment bank is
quite common. Jabil Circuit is in control of 25 facto-
ries around the world, but only nine are held as its
own property28.
Standardization of production lines and the adop-
tion of leasing systems are two of the main reasons
why EMS providers enjoy very high returns on their
fixed assets.
3. STRATEGIC ASSETS ARE ACCUMULATED
BY HIGH EMPLOYEE RETENTION RATE
AFTER PURCHASES
Strategic assets made up of core technologies and
related assets can be both tangible and intangible as-
sets and provide competitive advantages. EMS pro-
viders are able to increase strategic assets such as
design and production technology expertise through
its many purchases of factories and businesses. In
28 Toshihiro Yamada “Special Report: Seek Winners of the Internet Revolution]” (“Weekly Toyo Keizai” May 6, 2000)
pages 68~69
29 “Path to No. 1 - The Solectron Story] (Ohm “Electronics”, February 2000), page 11
30 Shoichi Terayama, Ryohei Yamazaki “Trends and Beyond Trends” (“Nikkei Business” October 30, 2000) page 8
JBIC Review No.4 13
many cases the vast majority of the factory employ-
ees are retained with their existing salaries and ben-
efits in place. For example, in the more than 20 major
purchases made by Solectron more than 85% of the
former employees are still employed.
The number of employees at the factories pur-
chased by the Solectron group actually increased two-
fold on average. In fact, the number of employees at
one factory in France purchased from IBM actually
increased almost 10-fold from 260 employees to just
under 3,000 current employees29.
These employees are familiar with the technolo-
gies of major high-tech firms, have the superior val-
ues of the large corporations and make it easier for
the EMS providers to obtain information on suppli-
ers of materials and components, and obtain equip-
ment for making advanced products. In other words,
these employees help the developing EMS providers
to quickly accumulate strategic assets.
In recent years American brand manufacturers
of computers have been placing greater emphasis on
software over hardware. As more investment is made
in research and development, the trend towards
downsizing and simplifying production facilities has
grown stronger. Along with this strategy change, fac-
tories have lost some importance and the morale of
factory workers has fallen. In some cases, options such
as selling the factory or using outsourcing have been
selected.
The basic policy of Solectron has been to offer
the employees of the purchased corporation the same
opportunities as its existing employees in order to
foster mutual trust. All employees are offered stock
options. Profit sharing and merit-based pay systems
have also been adopted. The corporation also uses a
system whereby each factory is free to determine the
basic wages for individual employees30. Solectron has
also established mechanisms by which it can grasp
important financial yardsticks for each line at its 57
factories worldwide. These financial yardsticks in-
14 How the EMS (Electronics Manufacturing Service) Business Model
Can Help Japanese Corporations Revolutionize their Factories?

Figure 14 Recent Purchases by Leading EMS Providers (including other than factories)

Solectron SCI Systems Celestica

1998 - NCR: Atlanta factory, Columbia
factory (US), Dublin factory
(Ireland)
- IBM: North Carolina electric card
factory (US)
- Mitsubishi Electric: Georgia
cellular phone factory (US)
- Nokia: Telephone factory
(Finland)
- Nokia: Terminal factory (Sweden)
- Ericsson: Mexico City factory,
Spain factory
- Madge Networks: Ireland factory
- Lucent Technologies: Mexico
factory
- HP: Massachusetts systems
factory (US)
- Analytic (US design and testing
company)
- Silicon Graphics: PCB factory
- Accu-Tronics (EMS provider in
US)
- IMS merger (EMS provider
covering Asia)

1999 - Sequel (personal computer
support)
- Smart Modular Technologies
(memory module design and
production)
- New Logics (IBM Maintenance
company in Canada)
- Glenayre (Illinois pager facility
(US))
- HP: Kunshan factory in China - Gossen-Metrawatt (Czech)
- Nortel Networks: Ontario factory, - HP: Massachusetts PCB factory
Quebec factory (Canada) (US)
- TAG (US maker of electronic
sealing materials)
- ECI Telecom: PCB factory
(Israel)

2000 - Ericsson: communications base - Stock in Uniwill (notebook PC - IBM: Minnesota electric card
factories (France, Sweden) maker in Taiwan) factory (US)
- Americom Wireless Service (US) - Nokia Engineering Group - IBM: PCB factory (Italy)
- Bluegum Group (EMS provider in - EOG (US design, EMS provider) - Bull Electronics (US affiliate of
Australia) - Telrad Networks: factory in Israel Bull group)
- IBM: Brazil PCB factory - CMS (US maker of electronic - NEC: communications
- Nortel Networks: factories in sealing materials) equipment factory (Brazil)
France, Northern Ireland and
Turkey
- Nortel Network’s CAD facilities
- Sony Nakaniida (Japan), Sony
Industries (Taiwan)
- Stock in NatSteel (EMS provider
in Singapore)

Note: Related Japanese companies are indicated by bold-faced type.

Source: Prepared by the author from Press Release (as of November 2000) of each company

clude cash flows, return on assets and return on eq-
uity31.
This idea of providing all workers with equal
opportunities helps to stimulate the employee moral
that had fallen with the previous corporation, and is a
reason for the high level of employee retention after
the EMS provider purchases the company.
Solectron was awarded the Malcolm Baldrige
National Quality Award (quality control award estab-
lished during the Reagan administration) in 1991 and
again in 1997. However, Solectron has continued to
set winning of this award again as a target for the
corporation. To this end it has created an environ-
ment fostering solidarity between existing employ-
ees and employees from the purchased corporation
and has incorporated quality improvement mecha-
nisms based on customer satisfaction indexes (CSI)
that make weekly assessments possible32. Other fac-
tors that cannot be overlooked include the employ-
ees’ shared awareness of customer satisfaction and
quality, as well as the creation of an environment
where teamwork can be easily put to use.

31 ibid. Page 8
32 Satoru Kawashima, Shoichi Terayama, Ryohei Yamazaki, Arata Satoh “Factories’ Declaration of Independence” (“Nikkei
Business” October 16, 2000) pages 32~33
 JBIC Review No.4 15

CHAPTER 5 Solectron is not the only corporation that is aim-

PERSPECTIVES OF INTER-
CORPORATE RELATIONSHIPS
1. BUILDING LONG-TERM PARTNERSHIPS
WITH SELECTED SUPPLIERS
Many EMS providers establish long-term partnerships
with their customers and suppliers. Solectron has had
business relationships of 10 or more years with IBM,
Hewlett-Packard, Sun MicroSystems, Apple Com-
puter and others (Handfield et al, 1999). The initial
customer-supplier relationship in the 1980s was
mainly a relationship based only on the transaction
characteristics. In the 1990s customers began devel-
oping strategic supply base management by focusing
on supply base optimization, measuring supply capa-
bilities, developing relationships with main suppli-
ers, and improving quality and delivery capabilities.
In the future these relationships will likely be main-
tain, while developing new relationships with suppli-
ers focusing on the performance of the overall sup-
ply chain, going beyond the simple ties between cus-
tomer and supplier (Handfield et al, 1999).
ing to develop intimate and long-term relationships
with its suppliers. In fact Dell Computers, which is
not an EMS provider, has introduced supply chain
management to reduce its more than 100 suppliers
down to around 25 corporations (account for more
than 90% of procurement in terms of value)*33.
Hewlett-Packard, 3M, Xerox and other corporations
have reduced the number of direct parts suppliers from
several thousands to several hundred, and many are
still trying to reduce this number to double-digits
(Kato, 2000).
Traditionally these American corporations have
used bidding systems and market transactions to de-
termine contracts and trading partners and avoid trad-
ing risks between businesses. So why are these same
corporations now so drastically changing their sup-
ply strategies?
One reason for this change in strategy has been
greater modulation targeting shorter lead times. An-
other reason is the intermediate transactions within a
network targeting cost reductions.

Figure 15 Customer and Supplier Relationships

New Relationship
Strength of Relationship with Supplier

with Supplier

Strategic Supply
Base Management

Business Relationship

Time
Source: Based on page 194 of “Introduction to Supply Chain Management” by Robert
B. Handfield and Ernest L. Nichols, May 1999, with additions by the author.

33 “Special Edition: Japanese and American Businesses Chasing Quality” (“Nikkei Business” March 2, 1998) pages 26~30, “Lecture:
Business Model” (“Nikkei Electronics” January 4, 1999) pages 179~186
16 How the EMS (Electronics Manufacturing Service) Business Model
Can Help Japanese Corporations Revolutionize their Factories?
2. MODULIZATION TARGETING SHORTER
LEAD TIMES
Modules are made by assembling parts. However, if
the functional contacts between modules are standard-
ized and made compatible, the modules themselves
can function as the product when connected. Some
40 years ago IBM introduced the first design
modulization for its System 360 computer. As a re-
sult IBM no longer had to design each product part
one by one. Product lead-times were said to be re-
duced by designing module units in concurrent (Sako,
2000). Another effect is the reduction in the amount
of communication needed between the organizations
responsible for each module (Kokuryo, 1999).
In this manner EMS providers have promoted
the modulization of computer-related products that
they are asked to produce. However, this standard-
ization has not led to external orders for individual
parts, but has made it easier to use outsourcing that
combines the design and production of the entire
module. This modulization that focuses only on the
suppliers that can shorten lead times has led to the
emergence of this new business known as EMS.
3. NETWORK-TYPE INTERMEDIATE
TRANSACTIONS TARGETING COST
REDUCTIONS
There is much contextual34 information in the busi-
ness transactions between Japanese corporations and
so trading risks are lessened through personal ex-
changes as opposed to contractual relationships. In
order to hold down transaction costs, the number of
trading partners is reduced and continuous, stable re-
lationships are built with proven corporations and
founded on the so-called “keiretsu” (business affili-
ate) trading system. These so-called “intermediate
transactions” are a cross between market transactions
and transactions within an organization.
However, in America bidding systems are gen-
erally used and market transactions are based on con-
tractual relationships. In order to reduce some of the
resulting transaction costs, some corporations have
34 Common interpretation though accumulated communication.
used merger and acquisitions as a means of bringing
the transactions within their organization. However,
mergers and acquisitions increase the size of the busi-
ness (business size increases from S0 to S1 as shown
in Figure 16), thus raising organizational costs. This
effectively cancels out any reduction in the transac-
tion costs (Takao Ito, 1999).
The Japanese-style “keiretsu” transaction system
is the better choice provided that the amount of con-
textual information, which is associated with higher
costs, can be successfully kept under control.
From the point of view of cost planning, part
suppliers for the “design-in” aspect of product devel-
opment do not generally participate in the bidding
process used by American and European countries,
which is not the case in Japan. However, from the
1990’s American and European businesses began
studying the mechanisms adopted by their Japanese
counterparts. The result was that they were able to
greatly reduce parts costs by letting the parts suppli-
ers participate in the initial stages of development.
This had a large impact in shifting cost plans more
toward the intermediate transaction style (Okano,
Shimizu, 1997).
Taking into consideration the issues of increas-
ing organizational costs and supplier commitments,
American corporations have adopted a network-type
intermediate organization making aggressive use of
information technologies and roughly corresponding
to the Japanese “keiretsu” style of trading (Takao Ito,
1997). In other words, attention is now being given
to this movement towards intermediate transactions,
which are seen as being somewhere between market
transactions and transactions within an organization.
EMS providers have been attracted to the strong
points of the Japanese-style “keiretsu” transactions
as a means around the fact that reductions in transac-
tion costs are cancelled out by increasing organiza-
tional costs due to their aggressive use of mergers
and acquisitions. Supply chain management has been
raised as one business model for coping with the cost
demerits of contextual information.
 JBIC Review No.4 17

Figure 16 Relationship between Business Scale and Transaction Costs, Organizational Costs

Costs

Organizational Costs
Transaction Costs

S0 S1 Business Scale
Source: Takao Ito “Network Organization and Information” (May 1999) page 126

4. STRICT SELECTION OF SUPPLIERS,
PROGRESS IN REORGANIZING
SUPPLIERS
Supply chain management is used to strictly select
and reorganize suppliers in order to focus on just a
few direct suppliers of key components.
Brand manufactures monitor in a very business-
like manner the production management of the EMS
providers, and then select and replace the EMS pro-
viders they use. Electronics For Imaging, an American
fabrication-less business developing signal processing
servers for color and digital images, operates a barcode
tracking system with its EMS providers to allow for
remote monitoring of at exactly which factory and at
which line parts are being assembled. Furthermore, a
virtual engine that uses a workstation for product tests
was supplied to an EMS provider to improve the effi-
ciency of quality inspections. This data on the produc-
tion management of the EMS providers are used to
select providers from the point of view of stable qual-
ity and “just-in-time” product provision35.
From the point of view of the EMS provider,
Solectron, for example, introduced the use of customer
satisfaction indexes in 1985. Every week conferences
are held to go over score sheets returned by the cus-
tomers covering various areas such as quality, speed
of delivery and response to inquiries. Those in charge
of areas that receive a score of 90 or lower must de-
termine the cause of the problem and take corrective
measures and other quality improvement measures
in order to raise the score by the following week.
Cross-functional teams are also organized for each
major customer. These teams are given authority over
specifications, production planning and part procure-
ment. At the same time a system is established as-
signing responsibility for each customer in terms of
earnings36.
The EMS provider works with the suppliers to
realize short delivery times and low costs. In a hori-
zontal specialization structure suppliers can be easily
selected based on price and delivery. The emergence
of EMS providers is due to the parts modulization

35 “Second Section America on a Fast Ride” ‘Nikkei Sangyo Shimbun’ February 2, 2000, page 24
36 “Path to No. 1 - The Solectron Story” (Ohm “Electronics” February 2000) pages 10~11; “Special Feature: Factories’ Declaration
of Independence” (“Nikkei Business” October 16, 2000), page 33; Japan Printed Circuit Association (“Report on Business Strategy
Vision for the Electronics Circuit Industry” January 2000) pages 52~53.
18 How the EMS (Electronics Manufacturing Service) Business Model
Can Help Japanese Corporations Revolutionize their Factories?

and standardization mentioned earlier, but it is also
due to the uses of many suppliers to low cost, quick
delivery times and tolerable quality37.
In the case of Solectron, for example, the main
standards for suppliers are (1) reliability, (2) lead time
in filling orders, (3) average time between problems
(quality), (4) allotment of all-purpose parts, (5) re-
duced inventory risks, and (6) cost reduction
(Handfield et al, 1999)
From the point of view of the supplier, procure-
ment by electronic commerce is accelerated, product
modulization is progressing and transaction price have
become more severe. Therefore, if the supplier, for
example, proposes a module product that has a con-
nector mechanism with an LCD open/shut mecha-
nism, the value of the part is likely to increase38. Also,
large quantities of information about the market are
promptly provided to the suppliers. These suppliers
are expected to quickly interpret and analyze this in-
formation, and then incorporate the information into
their own production and inventory plans39. As a re-
sult, suppliers that best demonstrate these capabili-
ties receive more business.
The arrangement of businesses in the supply
chain management of American EMS providers is
now being looked at very closely. Compared to the
business relationships within the Japanese keiretsu
system, which people both in and out of Japan have
described as being stiff, this is seen as a more open
and economically rational relationship.
5. IS SUPPLY CHAIN MANAGEMENT
A WIN-WIN STRUCTURE?
Supply chain management ahs been described as a
win-win relationship40 in which the participating busi-
nesses and divisions share their intentions and work
in a partnership, pulling their talents together to
achieve the overall best result. However, in reality
the overall control of the chain is applied regardless
of the size of the participating business, and this is
seen as a profitable structure as the earnings capa-
bilities of one’s corporation are improved41. This con-
trol is seen as the organization maintaining its own
autonomous power, while trying to expand the power
of other organizations when possible (Yamakura,
1993). This is in agreement with the resource depen-
dence perspective framework of the conventional
management organization relationships that are based
on this premise.
Dell Computer can again be cited as an example
of a successful application of supply chain manage-
ment.
Dell Computer has realized very high returns due
to its competitive strengths in the areas of personal
computer quality, delivery and price. Microsoft is the
much larger corporation, but Dell Computer is better
able to control its entire chain. The high profitability
of EMS providers is due to their realization that pro-
curement of materials and components is the most
profitable area along the entire chain. In other words,
with supply chain management any participating cor-
poration has the chance to be a leader for the entire
change regardless of its business size and ties with
other corporations.
When supply chain management is seen as a link
between the user and the supplier, it takes on a com-
position in which “BTO (build to order) strategies,
which do not have the inventory risks associated with
Dell Computer and other brand manufacturers, are
strengthened and the EMS providers make use of the
suppliers with the superior capabilities in handling
such orders”42. Product modulization and standard-
ization are premises for brand manufacturers like
Dell Computer, as well as for the EMS providers.

37 Japan Printed Circuit Association (“Report on Business Strategy Vision for the Electronics Circuit Industry” January 2000)
page 131
38 ibid. Page 74
39 “Special Feature: Streamlining Domestic Factories - Using the Internet and Outsourcing Production” (Fuji Research Institute
‘fai’ May 2000) page 6
40 A win-win relationship means that there are merits for both parties involved.
41 Yoshiki Matsushima “The Essence of EMS is Starting Factories” (Fuji Research Institute ‘fai’ May 2000) page 16
42 Japan Printed Circuit Association (“Report on Business Strategy Vision for the Electronic Circuit Industry” January 2000) page
129~130, “Nikkei Information Strategy” (August 1998) pages 18~19

Therefore, even if emphasis is placed on the speed
and costs of the suppliers participating in the chain,
the questions of technical prowess and individual-
ity are not really seen as problems. This has meant
that suppliers that are more technically oriented in
such areas as developing unique products have had
trouble gaining power within the organization and
in enacting expansion policies. There are also doubts
as to whether or not relationships based on mutual
trust can be fully developed as they are in the Japa-
nese keiretsu system. It has been said that the struc-
ture of these relationships supports exchanges be-
tween businesses that can freely enter and leave the
structure, but some see it as an organization with
fixed roles. Hanada (1996) said, “The individual
corporations actively provide their core competences
(corporations’ core capabilities in providing value),
and the mechanism for producing added values
through the tie-ups with other corporations is not
fully realized. The core competences become locked
up within the structure, and nothing more than mu-
tually complementing relationships are developed.”
However, most of these problems are associated with
the limits of the EMS model in starting up businesses
targeting products that are hard to differentiate in
the production process.
In order to reach a Win-Win situation, a frame-
work has to be found where core competences are
openly shared to develop new core competences
(Hanada, 1996). The ideal model is one in which
the superior technologies and individuality of the
participating corporations are actively incorporated,
the entire business is aware of participating in the
shared specifications, technologies and testing and
coordinates a supply mechanism. However, the EMS
business is likely to adopt business models with in-
dividual concepts.
43 “Nihon Keizai Shimbun” November 9, 2000, Morning Paper, page 13
44 “Nihon Keizai Shimbun” October 19, 2000, Morning Paper, page 11
JBIC Review No.4 19
CHAPTER 6
IMPLICATIONS FOR JAPANESE
BUSINESSES
1. INROADS INTO JAPAN BY EMS
PROVIDERS AND REFORMATION OF
FACTORIES OF JAPANESE
CORPORATIONS
Over the past few years, Japan has also seen active
mergers and acquisitions and divestitures. As greater
demands are placed on industries to raise their value,
more and more factory operations are being combined,
separated, sold off or outsourced as these corpora-
tions look to reorganize their business portfolios.
However, some factories have been trying to become
independent, breaking free from its ties to the parent
company and group. In other words, there have been
advances in the liquidation of production elements.
Foreign EMS providers are now starting to seri-
ously try to develop the Japanese market. The world’s
largest EMS provider, Solectron (US), purchased
Sony Nakaniida as its first production base in Japan.
The world’s third largest EMS provider, Celestica
(Canada) established a Japanese affiliate “Celestica
Japan”, which began operations from November
200043.
Japanese businesses have also started to
outsource more of its production. In other words, they
are starting to reform their factories.
In 2001 Sony began to aggressively distance it-
self from its production divisions by moving some
operations to a new company called EMCS (engineer-
ing, manufacturing, customer service). EMCS single-
handedly undertakes all manufacturing processes
from product and parts design and production to dis-
tribution and after sales service, and in this manner
provides service to the parent company and group.
At the same time EMCS is also eyeing the possibility
of providing services to companies outside of the Sony
group44. NEC has also announced that its five domes-
tic production affiliates plan to provide production
20 How the EMS (Electronics Manufacturing Service) Business Model
Can Help Japanese Corporations Revolutionize their Factories?
services to other companies in the same industry. In
fact, NEC Nagano has established a sales division and
has already started providing services for the produc-
tion of monitors and projectors. With more Japanese
corporations shifting production overseas, there has
been an excess of employees and facilities at domes-
tic factories resulting in stagnant production. To
counter this situation, many factories are trying to
become independent. Factories are being reformed
with consideration to employing workers and support-
ing the local economies 45 . From fiscal 2001
Matsushita Electric Industry began using domestic
factories and has begun accepting production orders
from group companies and other electronics manu-
facturers. This has helped to put the brakes on the
hollowing out of Japan’s production capabilities,
while helping to foster new businesses46.
Fujitsu is also considering turning some of its
overseas factories into EMS providers. The company
is currently building a cellular phone PCB factory in
Vietnam on the premise it will serve as a EMS47.
2. OUTSOURCING PROBLEMS
The following problems are being examined from the
points of view of outsourcing and the reformation of
factories.
Outsourcing is seen as a strategic consideration
for business resources. “Instead of total perpendicu-
lar internal unification, the use of superior external
services can make the business economically larger,
more flexible and provide more specialized tech-
niques. In terms of business strategy, only the essen-
tial elements need specialization. All other elements
should be handled externally to the greatest extent
possible” (Kobayashi, 1999, Quinn, et al., 1991). In
other words, the focus for production has shifted from
“how can we make things” to ‘’how can we entrust
production to capable suppliers” (Kobayashi, 1999,
Venkatesan, 1992). Peter F. Drucker also stressed that
“business resources other than the company’s core
competences should be externalized.”
45 “Asahi Shimbun” October 13, 2000, Morning Paper, page 13
46 “Nihon Keizai Shimbun” October 30, 1000, Morning Paper, page 11
47 Toshihiro Yamada, Toru Okamoto “Special Report: Learning from America’s High-tech Industrial Recovery” [Weekly Toyo
Keizai] July 17, 1999, page 35
American corporations embraced this philosophy
from the 1990’s and began aggressive outsourcing.
Clearly outsourcing had become the big trend. How-
ever, Japanese corporations, except for some of their
overseas affiliates, have resisted using EMS provid-
ers for everything from procurement of materials and
components to production. This has been due to their
awareness of the limits of outsourcing in the process-
ing and assembly stages, and some of the other rel-
evant problems.
One limit to outsourcing is that over the long-
term expertise does not remain within the organiza-
tion and the effectiveness in managing that area is
lost. Accordingly, from the point of view of creating
the organization, there is the problem of how to gen-
erate new values and in what form the outsourced
information will take for the corporation itself
(Hanada, 1996). Effort is needed in sharing external
resources with EMS providers and in collaboration
to create added value.
3. PROBLEMS REFORMING FACTORIES
One problem with reforming factories is that profit
levels for processing and assembly in the brand
manufacturer’s value chain decreases, and personnel,
facilities and other fixed expenses involved with pro-
duction are increased. Therefore, there has been the
effort to take on production from corporations out-
side of the group in order to maintain operating ratios
and improve productivity. However, how this is
achieved is probably different from the methods used
by the American-style EMS provider business. This
is because the EMS provider profit structure men-
tioned earlier [sales expenses and general operating
expenses rate: average of 4.6% for top 6 EMS pro-
viders] is an extremely low-cost operation that can-
not be imagined by Japanese industries. Moreover,
in the value chain 80% of sales are from procurement
of materials and components, while only 20% of sales
are from processing and assembly. In other words,
this type of earnings structure is a huge change for

factories built on the concept of production.
Despite the different aims, much can still be
learned from the EMS business model. One impor-
tant point is to establish functional relationships be-
tween the party making the order and the party filling
the order. Roughly the same problems are seen when
using outsourcing. The factories of Japanese corpo-
rations must consider two points when creating a func-
tional relationship from the point of view of an open
sub-contractor48. The first consideration is contextual
skills, which require a great deal of transactional costs.
Another problem to consider is the switch to a ser-
vice-type industry.
(1) Contextual Skill Problem
First of all, skill must be classified as either func-
tional skill or contextual skill. “Functional skill is fit-
ting for executing a certain assignment and gaining a
certain aim, and it is an ability employed for that pur-
pose based on a personal principle. Contextual skill
means relatively limited space of action. That is, this
skill can be coexistently combined and recombined
with minimum valid diversity49 of functional skill
which belongs to self and non-self in the context of
action. It cannot possibly exist without functional
skill.” (Nishiguchi, 1996).
The structural relationships between Japanese
assembling firms and parts manufacturers support the
deep development of contextual skills through their
direct contact. There is mutual commitment within
the organization, resulting in high performance
(Nishiguchi, 1996). However, some of these merits
can become demerits considering the rapid changes
in technologies, shorter product lifecycles and height-
ened market competition. When the ordering corpo-
ration is deemed as not having core competences,
outsourcing can be carried out. In order to reduce risks
sub-contractors prefer to an open relationship with
48 An open subcontractor is one that does not limit itself to a particular client. In a narrower sense, this also means one that does not
limit itself to a particular in-house company or division.
49 Ashby is indicating the law of minimum valid diversity in which the system is not suited to the environment unless it has
diversity exceeding the diversity held by the environment.
*50 Based on an interview by the author with President Yasui, Solectron Japan (November 22, 2000)
*51 “Nihon Keizai Shimbun” March 30, 1998, Morning Paper, page 11
*52 The “smile curve” refers to the point in the producer’s value chain where the added value of the mid-stream processing and
assembly procedures curves downward.
JBIC Review No.4 21
the contractors. Standardization supports economic
streamlining and supply chain management helps to
reduce inventories. When the party placing the order
relies on contextual skill-type outsourcing, it pressures
the subcontractor in terms of transaction expense and
speed. This existence of skilled competence has made
it difficult for foreign EMS providers to develop the
Japanese market (Solectron first opened a Japanese
office in 1992, but did not obtain its first domestic pro-
duction base until eight years later in October of 2000).
(2) Problem of Switch toward a Service Industry
EMS providers boast of being “a service that meets
the various needs of various customers in various
businesses”50. There are customers that want to rush
a new product to the market, and there are corpora-
tions looking to reduce costs. Solectron has a plant
that produces only printed circuit boards. This plant
produces around 1,200 different boards each day, and
for roughly two-thirds of these boards the designs and
production amounts change within a 24-hour period.
There are even customers that will suddenly request
production of a completely different product, and so
EMS providers must be ready to meet any such or-
der51. EMS providers do more than just procurement
of materials and components, and production. They
have expanded their range of services to include de-
sign, maintenance and other services to better meet
customer needs. Service has been generally defined
as labor outside of the physical production processes
(according to the Kojien dictionary). However, when
the factories of a Japanese corporation assumes the
role of a subcontractor, it must do more than simply
provide assembly technologies at the production cite.
It must also offer a wide range of services from de-
sign and parts development to maintenance. This is
affectionately called the “smile curve”52 that is a policy
for raising the level of added value.
22 How the EMS (Electronics Manufacturing Service) Business Model
Can Help Japanese Corporations Revolutionize their Factories?
On the other hand, the service industry of the
EMS provider is based on the premise of having no
brand. There are of course doubts that the factories of
large corporations that have prided themselves on their
own brands will now be able to provide a brand-less
subcontracting service and be able to flexibly meet
the demands of clients with vastly different corpo-
rate cultures. In order to make this switch to a service
industry based on customer satisfaction indexes and
a system responsible for each customer, a fair deal of
change will be needed for the organization’s culture
and attitudes.
The EMS provider initially starts out handling
only consigned processing (receives equipment and
parts from the customer). In the second stage the EMS
provider expands its customer base and acquires its
own facilities. In the next step it finally has the turn-
key capabilities to purchase materials and components
on its own53. Among Japanese corporations, suppli-
ers and parts companies that have independent busi-
nesses similar to this turnkey may possibly become
system suppliers54 developing complex parts or multi-
agents for several corporations. This is probably simi-
lar to the EMS business.
Generally speaking, the factories of large Japa-
nese corporations, including those overseas, tend to
rely heavily on a particular corporation or division
within the group. If these factories can move away
from this dependent relationship and can accept pro-
duction orders from another companies and divisions
within the group, they should then be able to begin
accumulating expertise as a service business.
CONCLUSION
We are now in an age in which the business manage-
ment environment is rapidly changing. Inevitably,
corporations will need to change from the conven-
tional strategy of keeping personnel, physical, mon-
etary and information resources focused within one
53 Based on an interview by the author with President Yasui, Solectron Japan (November 22, 2000)
54 Supplier capable of accepting an order for entire sub-system.
organization, while trying to pursue scale of profit.
This is especially true for the manufacturers of IT-
related equipment. With the fast pace of technical in-
novations and shorter product lifecycles, corporations
must now carefully consider the merits and demerits
of keeping production facilities within the organiza-
tions.
Along with the greater modulization of electronic
components, EMS providers have been able to exer-
cise strong bargaining power in procuring compo-
nents, while remaining sensitive to lead times for cus-
tomers and markets. In this manner the EMS provid-
ers are able to help the brand manufactures to im-
prove speed and reduce inventories.
The spread of the Internet has produced a digital
society and increased demands for greater speed and
flexibility. EMS providers, based on horizontal spe-
cialization, aim to be a network-based service indus-
try that builds mutual relationships between busi-
nesses in a virtual structure. Business value is based
on improving free cash flow.
If the factories of Japanese corporations, includ-
ing overseas affiliates, want to reform to become pro-
duction subcontractors, they will need to overcome
the problems mentioned earlier (contextual skills and
switching a service industry). However, some of these
corporations have started receiving orders from other
companies and divisions within their own group. How
will these factories maintain a competitive edge over
American EMS providers that have been promoting
standardization (for example, cost advantages, time
advantages and individual advantages in areas such
as diversification, miniaturization, device develop-
ment, and variable production skills)? Problems still
exist in terms of incorporating the technical skills and
individuality of the suppliers – standardization – and in
terms of cost and speed demerits – contextual skills –. It
will be important to see if a Japanese business model
can be created in the domain located somewhere be-
tween this standardization and contextual skills.

TERMINOLOGY
ASIC: Abbreviation for Application Specific Inte-
grated Circuit.
BTO: Abbreviation for Build to Order. Production and
sales in accordance with the order from the cus-
tomer.
CTO: Abbreviation for Configure to Order. Specifi-
cations based on the customer’s order.
EMS: Abbreviation for Electronics Manufacturing
Service. Consigned manufacturing service of
electronic equipment.
ERP: Abbreviation for Enterprise Resource Planning.
Methods and concepts with the aim of optimiz-
ing resources throughout the organization.
FPGA: Abbreviation for Field Programmable Gate
Array. IC in which the user can write its own
program.
LCD: Abbreviation for Liquid Crystal Display.
OEM: Abbreviation for Original Equipment Manu-
facturing. Complete products and components are
provided under the customer’s brand name.
PCB: Abbreviation for Printed Circuit Board. Boards
mounted with electronic component.
SCM: Abbreviation for Supply Chain Management.
Management method in which related corpora-
tion and division information is shared in real-
time to improve speed and efficiency for the en-
tire chain.
TTC: Abbreviation for Time to Customer. Time
needed to deliver the product to the customer
TTM: Abbreviation for Time to Market. Time needed
to deliver the product to the market.
REFERENCES
Japanese References
Ito K., [December 1999], “Adjustment and Validity
of Outsourcing Theory” (“Production Manage-
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tion)
Ito T., [May 1999], “Network Organization and In-
formation”, Hakuto Shobo, pp.124-128 (partly
excerpted)
JBIC Review No.4 23
Okano H., Shimizu N., [March 1997], “Overseas
Development of Prime Cost Plan”, (Yoshida H.,
Shiba K. “Theory of Global Management Ac-
counting”, Taxation and Accounting Association)
pp.112-138
“The Cases of Economic Rebirth in the Over-
seas Countries”, [December 1999], (“Kansai
Economic Rebirth Scenario, Separate Issue”,
Kansai Federation of Economic Organizations)
Kashima H., [December 1999], “Production Manage-
ment of Fabrication-less Enterprises”, (“Produc-
tion Management”, Japan Production Manage-
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Kato Y., [September 2000], “Supply Chain Manage-
ment: Perspectives of Inter-organization Rela-
tionship Management”, (“Business Insight Vol.8
No.3”, Modern Management Research Associa-
tion), pp.34-35 (partly excerpted)
Kokuryo J., [November 1999], “Open Architecture
Strategy -Collaboration Model in the Age of Net-
work-”, Diamond Publishing Co.), p.116 (partly
excerpted), p.101 (excerpt), p.178 (partly excerpt)
Kobayashi K., [September 1999], “Theory and Ap-
plication of Management Strategy”, Hakuto
Shobo), pp.111-112
Sako M., [May 2000], “Supplier Relationships
Changed by Modulization” (Osaka City Univer-
sity, Department of Commercial Science and
Department of Economics “21st Century System
and Japanese Enterprises”, Nihon Keizai
Shimbun) pp.254-260 (partly excerpted)
Deguchi H., [July 1996], “Open Sourcing that Pro-
motes Autonomous Dispersion” (Diamond
Harvard Business Editing Section “Practice of
Outsourcing and Organizational Evolution”,
Diamond Publishing Co.) pp.208-209 (partly ex-
cerpted)
Nishiguchi T., [July 1996], “Inter-organization Rela-
tionship Management of Symbiotical Evolution”
(Diamond Harvard Business Editing Section
“Practice of Outsourcing and Organizational
Evolution”, Diamond Publishing Co.) p.157 (ex-
cerpt), pp.137-138 (partly excerpted)
24 How the EMS (Electronics Manufacturing Service) Business Model
Can Help Japanese Corporations Revolutionize their Factories?
Hanada M., (July 1996), “Creation of Future Organi-
zation by Multiple Co-sourcing” (Diamond
Harvard Business Editing Section “Practice of
Outsourcing and Organizational Evolution”,
Diamond Publishing Co.) pp.11-12 (partly ex-
cerpted)
Yamakura K., [April 1993], “Inter-Organizational
Relationships -Toward the Reform of Inter-cor-
porate Network” Yuhikaku, pp.35-41, 63-71
Handfield R., Nichols E., Translated by Shin-Nippon
Steel, EI Business Dept. (May 1999), (“Supply
Chain Management Overview” Pearson Educa-
tion) pp.198-201, 196-197 (partly excerpted),
201-203, 186-187, 193-194 (partly excerpted),
195 (excerpt)
English References
Brian Rothery and Ian Robertson, “The Truth About
Outsourcing”, Gower Publishing Limited, 1995,
pp.133-139, 177-185.
aaaaaaaaaaaaa
Cary L. Cooper and Denise M. Rousseau, “The Vir-
tual Organization”, John Wiley & Sons, Ltd.,
1999, pp.15-30.
Jeffrey Pfeffer, 1987, “A resource dependence per-
spective on intercorporate relations”, in Intercor-
porate Relations, Cambridge University Press,
pp.25-55.
Quinn, J.B., Doorley, T.L., and Paquette, P.C., “The
Intellectual Holding Company: Structuring
around Core Activities”, in The Strategy Process,
Englewood Cliffs, N.J.,: Prentice-Hall Inc., 1991,
pp.324-330.
Steven L. Goldman, Roger N. Nagel, Kenneth Preiss,
“Agile Competitors and Virtual Organizations”,
Van Nostrand Reinhold, 1995, pp.201-234.
Venkatesan, Ravi., “Strategic Sourcing; To Make or
Not to Make”, in HBR, 1992 (Nov.-Dec.), pp.98-
107.

CHATTEL COLLATERAL LAWS OF BULGARIA,
RUMANIA AND HUNGARY AND JAPANESE ENTERPRISES’ BUSINESS
Koji Suzuki*
SUMMARY
Japanese manufacturers’ investments for the EU mar-
ket, which was prone to be concentrated into Britain,
are being directed to Central and East Europe where
the market economy has been in progress, partly trig-
gered by the weak Euro. In Central and East Euro-
pean countries, using the EBRD’s 1994 Model Law
on Secured Transactions as a reference, legislation of
chattel collateral laws as their business laws of mar-
ket economy has been under way. Legislating opera-
tions of chattel collateral laws have also been in
progress in the ASEAN countries, such as Indonesia,
Vietnam and Thailand, after the ASEAN currency
crisis, receiving advice from the World Bank. In Asia,
legislation of the chattel collateral law is in motion as
means of reforming the financial institutions that were
too much dependent on real estate collateral financ-
ing. On the other hand, in Central and East Europe
where enterprises cannot easily offer real estate as a
security, legislation proceeds from the standpoint of
developing a new corporate finance so as to supply
fund procuration means using movable properties and
claims as securities.
There is not much significance in legislation un-
less the law is actually used. To examine whether or
not the law is actually used, the analysis of conative
impulse proposed by Häger Ström, a legal philoso-
pher, is necessary. Doing the analysis of will impe-
tus, while introducing the content of the Law on Reg-
istered Pledges of Bulgaria, we can see a characteris-
tic of forming chattel collateral as right of pledge and
not as collateral of fiduciary transfer. Although there
is an inconvenience that certain pledges require to be
* Senior Economist, Director of Research Institute for Development and Finance
JBIC Review No. 4 May 2001 pp 25~56
©2001 by Japan Bank for International Cooperation. All rights reserved.
JBIC Review No.4 25
registered twice, the merit of clear processing in col-
lateral execution exceeds the former. A tendency of
doing unsecured business in case no Japanese collat-
eral nor guarantee of Japanese enterprises is avail-
able is seen in the business of Japanese enterprises in
developing countries, but concerning business in
countries like Bulgaria, Rumania and Hungary, it is
advisable to keep in mind doing business based on
registration of the right of pledge of local companies
including local subsidiaries. Otherwise, insufficient
debt collection, or a situation such that the local sub-
sidiary as a successful result of local investment be-
comes the target of LBO (leveraged buyout), using
the account receivables as a security, might occur.
CHAPTER I
NEW LEGISLATION OF CHATTEL
COLLATERAL LAWS IN CENTRAL
AND EAST EUROPE AND ASIA
1. CAUSES OF JAPANESE ENTERPRISES’
LAUNCH INTO CENTRAL AND EAST
EUROPE
(1) Japanese Enterprises’ Launches into Central
and East Europe and Chattel Collateral Law
Japanese enterprises’ launches into Central and East
Europe, including Hungary, Poland and Slovakia have
become marked since 2000. The sudden drop in Euro
rate after 2000 can be considered a direct cause. Pro-
duction bases in EU of Japanese enterprises were lo-
cated Britain by an overwhelming majority. As the
British pound does not join Euro, its rate has increased
26 Chattel Collateral Laws of Bulgaria, Rumania and Hungary and Japanese Enterprises’ Business
about 30% by the sudden drop in Euro, and the at-
tractiveness of Britain as a production base in EU has
rapidly decreased. The choice is either to decrease
the production capacity in Britain or to move facto-
ries to Euro countries, or otherwise the competitive
force in the Euro market will drop by 30% of the
higher pound. For example, Bulgaria adopts the cur-
rency board using Deutsche mark. Mark is closely
linked with Euro, and since the financial policies of
the country receives wide restrictions under the cur-
rency board, there is no significant inflation or de-
valuation. Located within the Eurozone as a produc-
tion base aiming at the Eurozone as a consuming area,
Bulgaria where the level of per capita national in-
come is much lower is hopeful as a production base
with lower production costs. However, in Bulgaria
the investment environment must be clearer. Coun-
tries like Hungary, Poland, Slovakia and Czech are
known for the advanced destatization, and foreign-
based enterprises can have a conviction that they can
do business on international business rules, to a de-
gree. Whereas, compared with these four countries,
the investment environment in Bulgaria and Ruma-
nia can be said to leave subjects toward further clari-
fication, including the degree of progress of market-
oriented economic reform.
Although it is said that, in connection with the
expansion of the EU to the east, there are merits of
launching into Central and East Europe where qual-
ity human resources are available at low costs, for
the author the explanation seems too general. In
Hungary, Czech and Slovenija, production costs of
export-oriented foreign-based enterprises are increas-
ing drastically. In Slovakia and Poland too, the situ-
ation can be said to become the same. Namely, it can
be said that the time of participation in the EU is ap-
proaching can be said that their living standards has
come up to the EU level. Although there is still time
before joining the EU (probable 2007 or later), Bul-
garia and Rumania are promising as target countries
of investment where the investment can be collected
in five years or so, if only the business environment
becomes clarified. The chattel collateral law to be
discussed in this text is important as a legislation to
ease business. Because, local companies can get lo-
cal finance, using their own accounts receivable. This
minimizes the parent companies’ burden as to invest
and finance their local subsidiaries by procuring funds
and bearing exchange risks themselves. Each parent
company can secure an additional chattel collateral
corresponding to the exchange risk, and by securing
the export account receivable, on the same currency
as that of the finance, as a collateral, they can even
get rid of the exchange risk.
(2) Is the Reason for Launch into Britain Applicable
to Launch into Central and East Europe?
When Japanese enterprises launched into Britain, (1)
personnel expenses in Britain were overwhelmingly
lower compared with production in consuming mar-
kets like Germany, France and Benelux, (2) commu-
nication with workers at local factories in English,
which Japanese engineers could use, and (3) Britain
that has been accepting a lot of Japanese tourists for
years is familiar to Japanese people, are major rea-
sons. Other reasons many include the following: (4)
while labor unions were weakened under the Thatcher
government, trade unions in Germany and France had
an image that they were powerful and had strong re-
quests for improving labor conditions; (5) facts that
there was an international finance market of London
and Japanese banks had launched there from before,
and that those Japanese banks acted as useful infor-
mation sources for launching areas also contributed
to making decisions about launch into Britain; (6) for
launch into Italy, the reason that it was not examined
so much seems that the image of a country involving
high inflation and political complication was strong
among Japanese people; and (7) Launch into Ireland
where English as the official language had been popu-
lar during the 1980s, but launch rash was not so much
compared with Britain due to reasons of it being a
small country with poor access of physical distribu-
tion and that it would not be possible to expect local
finance there.
Of the above reasons of launch into Britain, rea-
sons that can be applied to launch into Central and
East Europe are only items (1) and (4). On the other
hand, as reasons that were not applicable to countries
other than Britain but seem to be applicable to Cen-
tral and East Europe, items (2), (3), (5), (6) and (7)
can be mentioned, as commented below. For item
 JBIC Review No.4 27

(4), the organization power of trade unions, includ-
ing the Solidarity Union of Poland, rapidly became
weak under the old system after the collapse of the
socialistic system, and not only new trade unions do
not readily come out but also the power of newly born
trade unions is weak. For item (3), tourists going to
Czech and Hungary are increasing but it is only be-
cause these countries have become popular for rea-
sons of curiosity and enjoyment of medieval Europe
at low prices, and, these countries are not yet so fa-
miliar to the Japanese as to prepare direct flights and
we shall not be able to have so much expectation even
in the future. For item (2), the number of English-
speaking human resources is very small, and local
languages are not so easy for the Japanese to master.
For item (7), Central and East European countries are
small, each having a small population.
(3) Weak Euro and M&A
As described above, launch into Central and East
Europe is given consideration despite but a few points
common to launch into Britain, just because the weak
Euro and non-participation in Euro of the sterling
pound are expected to continue for the time. Expan-
sion of EU enterprises’ overseas investments in the
United States, mainly M&A, is one of the causes of
weak Euro. EU enterprises’ M&A in countries out-
side the Eurozone means selling Euro and buying
dollar1. Enterprises of the Eurozone buying British
enterprises means selling Euro and buying pound.
Since funds for EU enterprises to have their produc-
tion bases in Central and Eastern countries, in South-
east, South and East Asia and in South America is
dollar, they have to sell Euro and buy dollar. Of
course, European investors once bought dollar and
invested it in the US stock market when the US stock
market continued to be brisk. It seems that the de-
cline of Euro has proceeded further because specula-
tive players handling hedge funds and the like, judg-
ing that the basic tone of selling Euro and buying
dollar will not change, are reacting susceptibly and
increasingly applying the pressure of Euro selling.
2. CHATTEL COLLATERAL LAW AS PART
OF LEGAL SYSTEM REFORM
(1) Chattel Collateral Law and M&A
M&A outside the Eurozone by EU enterprises will
be continued so far as competitions with US enter-
prises adds severeness in the global market. One of
arms for promoting M&A outside the EU is the chat-
tel collateral law discussed in this text. In the legisla-
tion of the chattel collateral law, often the collateral
registration of unspecified accounts receivable of the
future, as well as the collateral registration of collec-
tive movable properties in stock and specified future
credits, are recognized. Namely, by opening the way
for movable properties as well as real estate, it is in-
tended to facilitate financing by financial institutions.
The unspecified account receivable of the future is in
a word the future cash flow of the enterprise. When
the future cash flow of the enterprise is expected to
be fairly above the market value of stocks of the en-
terprise, it is worth buying. Buying by securing fi-
nance, using the future cash flow of the target enter-
prise of leveraged buyout (LBO), is also possible
when the unspecified account receivable of the fu-
ture can be registered as a collateral. The chattel col-
lateral system under UCC Article 9 of the United
States has an aspect of promoting M&A, including
LBO in USA2.
EBRD recommends the legislation of the chat-
tel collateral law as part of the legal system reform
necessary for promoting system transition in Central
and East Europe/CIS countries. The key point of the
Model Law on Secured Transactions announced by
EBRD in 1994 is this chattel collateral registration
system. However, the intention of EBRD’s recom-

1 According to Financial Times of October 24 2000, overseas investments by enterprises in Eurozone include 49% for the United
States and 22% for Britain. In 1999, US$73.6 billion, one third of M&A across the whole world, flew into the United States, and
Deutsche mark dropped 39.4% against dollar during 22 months since January, 1999.
2 As an example of the chattel collateral system, UCC Article 9 of the USA and the Floating Charge of Britain can be mentioned.
Although there can be many M&A cases done by methods other than LBO via chattel collateral registration, it seems that the fact the
LBO by chattel collateral is available lowers the hurdle to M&A for management people.
28 Chattel Collateral Laws of Bulgaria, Rumania and Hungary and Japanese Enterprises’ Business

mendation of legislation is not promotion of M&A.
It is because of an expectation that, in these countries
that were once under the USSR-type socialist system
and where land cannot easily be available as a collat-
eral, financing will be activated and the private en-
terprise sector will grow when new collateral means
are supplied. In the future after the private enter-
prise sector grows, the chattel collateral registration
system may be uses as means of M&A, but it must be
gratifying that enterprises attractive as the target of
M&A are increasing. Since M&A by big Western
enterprises will deepen economic relations with them,
it will make economic integration as EU more close.
(2) Necessity of Chattel Collateral in Central and
East Europe
Under the USSR-type socialist system, land was ei-
ther state-owned or public-owned. Not allowing pri-
vate land holding makes it difficult to secure finance
using land as a collateral. Of course, there was a way
to obtain finance by using the right of land use in-
stead of the land ownership, but it was not easy to use
the right of land use as a collateral because of a diffi-
culty in evaluation compared with the land owner-
ship. Since a consciousness that naturally land is
public-owned and the right of residence is secured
by the state even after the collapse of the socialist
system rooted among the nation, the use of land own-
ership as a collateral does not easily proceed in Cen-
tral and East Europe3. For the people of Central and
East Europe, it is acceptable to borrow money on the
security of the land on which his/her house is built
but it is not agreeable to lose the land and house and
driven out of the place of residence when he/she can-
not repay the debt. Further, the question is land for
business operation. Since land for business opera-
tion had been occupied by state-owned enterprises
before, formation of the market for the ownership of
land for business operation has not been developed.
For privatized state-owned enterprises, land is to lease
and not to sell. Also, when land is sold, since only
foreign capitals have funds to purchase big land lots,
it will only promote land purchase by foreigners and
cause a political issue.
Under the situation there is no distributing mar-
ket of the land ownership, it is not easy to use the
land ownership as a collateral. The building owner-
ship can be used as a collateral, but since the land and
building are filed in the same register, often it is diffi-
cult to set the mortgage right to the building when
owners of the land and the building are different.
Thus, as collaterals other than real estate, such as land
and buildings, movable properties and credit can be
considered. We can take products in stock, raw ma-
terials, factory machinery, cars, stocks and other mov-
able properties as collaterals. Further, by taking ac-
counts receivable as collaterals, this will makes it
easier for newly established enterprises having only
small physical assets and enterprises supplying ser-
vices to obtain finance. Also, there are companies
like leasing companies that need to get finance on the
security of their lease credits. For a company at the
foundation stage, the burden to purchase systems and
machinery themselves is heavy and a big deprecia-
tion adversely affects the profitability. And, in fields
of rapid technological innovation, the systems and
machinery need to be replaced before the deprecia-
tion is finished. Promotion of the leasing industry is
necessary for creating new, growing private sectors,
and in this sense provision of credit collateral finance
is desired.
Locally capitalized financial institutions in Cen-
tral and East European countries are generally said
as they lack abilities to supply funds to the private
enterprise sector due to little accumulation of know-
how to cope with nonperformance loans and check
credit standing. So, they sell their equity capitals to
foreign capitals to supply funds, by investing fund

*3 For example, in Bulgaria, the “Law relating to possession by people” stating that the real estate owned by a household is limited
to one 100m2 real estate for normal living and one 60m2 real estate for cottage use was alive till 1990, after the collapse of the socialist
system. Also, under the “Law relating to farming land and its possession,” possession by a non-resident is not allowed even today, and,
even for a resident, farming land holding per household is limited to 300,000m2 (Sergei Milanov “Legal System in Bulgaria,” NBL
vol.496, p.36)
 JBIC Review No.4 29

procured overseas as foreign-based financial institu- 3. DIFFERENCE IN LEGISLATIVE

tions, too.4 However, newly established private en-
terprises have only small assets that are available
as collaterals. Making use of their know-how, the
foreign capitals offer loans based on the cash flow,
but they cannot believe the newly established enter-
prises so much as to offer unsecured finance. Thus,
unspecified accounts receivable of the future and
products in stock are taken as collaterals. They come
to think it worth taking movable properties of which,
unlike the case of real estate, the ownership itself is
transferred by occupancy when these collaterals are
registered at national institutions and transfer itself is
easy, and, when the private auction of collaterals is
permitted by the chattel collateral law, collateral ex-
ecution is also easy.
Alpha Bank, which the author visited in Ruma-
nia on April 26, 2000, is the type of such foreign-
based banks. Greek Alpha Bank bought the capital
of a Rumanian state-owned bank and obtained the
right of management, and due to a shortage of fund,
finally bought the whole capital of the Rumanian side.
Finance has become concentrated on Greek-based
enterprises operating in Rumania. Finance to Ruma-
nian-capital enterprises is also considered. However,
as the cash flow of those enterprises itself is unstable,
and without collaterals, financing has to be made little
by little through the introduction of correspondent
Greek-based enterprises. The chattel collateral law
under Law on Promotion of Economic Reform, 1999
has been established, but as collateral registries are
not available yet, no finance on account receivable is
offered. Their purchase of the Rumanian bank merely
means that it bought the physical branch network, and
relations with branch correspondents during the time
of socialism are mostly discarded.
BACKGROUND OF CHATTEL
COLLATERAL LAW BETWEEN ASIA AND
CENTRAL AND EAST EUROPE
(1) Asia: Too much Dependence on Real Property
Mortgage Finance
In Asia, too, the movement of legislation to recog-
nize chattel collaterals by registration is rising. In
1999, in Indonesia and Vietnam, chattel collateral reg-
istration was legislated by the Fiduciary Transfer Act
and the Government Ordinance No. 165 on Registered
Movable Collaterals, respectively. In Thailand, the
draft Business Collateral Law is almost finalized at the
Ministry of Justice and legislation is expected during
2001.5 The Japanese “Law relating to Special Cases
of the Civil Code on Perfection of Credit Transfer of
1998” can be considered as part of it.
The background of such successive legislation
in Asian countries is different from the background
of legislation in Central and East Europe. In Central
and East Europe, where real estate centering on land
is actually not available as a collateral, they try to
newly supply fund procuration means of enterprises
by registering movable properties and credits as
collaterals. In Asian countries, where the excessive
supply of finance dependent on real estate collateral
soared the value of real estate, and financial institu-
tions had nonperformance loans with them when the
investment boom was over. Thus, development of
collateral means, other than real estate collateral, be-
came necessary. In Asia, under the pretext of diver-
sifying fund procuration means of enterprises, the aim
of legislation is to make financial institutions sound.6
It is possible to argue that, in Vietnam, a social-
ist country, the situation is the same as in the for-
merly socialist countries of Central and East Europe

4 According to Financial Times of October 20 2000, as of the 1999 year end, 41% of total bank assets of the formerly socialist
countries of Central and East Europe was occupied by foreign-based banks. Viewed by countries, 55% in Bulgaria, 18% in Rumania,
51% in Hungary, 44% in Poland, 49% in Czech, and 25% in Slovakia. The newspaper also reported that while the ratio of total bank
assets to GDP was 254% in the whole of Euro countries, it was only 69% in the whole of formerly socialist countries of Central and East
Europe.
5 These contents are discussed by Koji Suzuki “Draft Business Collateral Law of Thailand,” Report of Research Institute for
Development and Finance, vol.4, Oct. 2000.
6 Besides, legislation to make financial functions sound have been realized, including revision of the central bank law, revision of
the bank law, and establishment of the nonperformance loans buying agency (AMC).
30 Chattel Collateral Laws of Bulgaria, Rumania and Hungary and Japanese Enterprises’ Business
in that land cannot be used as a collateral. How-
ever, in Vietnam where state ownership of land is
the only way, the right of using the land where the
factory is located was naturally taken as a collateral
by taking a real estate of factory building as a collat-
eral. For Vietnam, it can be said that banks were too
much dependent on real estate collaterals in a sense
that, since the one-enterprise-one-bank account sys-
tem lasted till around 1997, banks had no other choice
but to repeatedly finance enterprises by using the same
real estate, namely the same land and buildings. In
China, land is either state-owned or cooperative-
owned. It is also pointed out as a reason that state-
owned commercial banks came to have
nonperforming assets as a result of financing to state-
owned enterprises because, in financing to province
and prefecture-class national enterprises, executives
of province and prefecture-class people’s committees
worked on executives of the state-owned commer-
cial banks. Since only secured finance was allowed
till the making of the Rules on Loans of Central Bank
of 1996, in the above cases, too, they made additional
financing on the same land and buildings. In this
sense, they were also too much dependent on finance
on the security of real estate.
(2) Local Banks, Enterprises and Foreign Banks
After the Asian Currency Crisis, the World Bank has
given advice of legal reform in Asian countries. Both
the bankruptcy law and competition law put stress on
legislation of the chattel collateral law and at the same
time on judicial reform. It is because the slow pro-
ceeding of bankruptcy procedures and collateral ex-
ecution has generated special relations between fi-
nancial institutions and enterprises and this exerts
adverse effects on fund supply. As the chattel collat-
eral law allows collateral execution by collateral reg-
istration, without passing through courts (so to say
“private sales”), prompt collateral execution is ex-
pected.
Characteristic relations between financial insti-
tutions and enterprises on collateral supply are men-
tioned, by countries, in the following. In Indonesia,
real estate mortgages are formally supplied to state-
managed commercial banks, and finance from finan-
cial clique-based banks to local financial cliques is
generally unsecured finance. In Thailand, four ma-
jor private commercial banks occupy real estate mort-
gages, and foreign banks and foreign-based banks fi-
nance these four major private commercial banks us-
ing the BIBF (Bangkok offshore finance market). In
Malaysia, racial local financial cliques (Bumiputra
financial cliques) and Chinese local capitals give the
first priority of real estate mortgage to banks closest
to them. In Philippines, local financial cliques have
capital relations with commercial banks, however, as
these banks are small in scale and as the compliance
of financial institutions became strict since the Mexi-
can crisis of 1982, conditions has continued to be
against procuration of business finance.
A fact that is common to these Asian countries
is that finance to local financial cliques offered by
onshore or offshore foreign-based banks is not se-
cured by real estate collaterals. Partly due to their
anxiety about court functions, they seem to have of-
fered loans to local foreign-based enterprises either
by taking the guarantee from their parent compa-
nies at home or without taking any security. The
chattel collateral law will enable these onshore and
offshore foreign-based banks to finance local finan-
cial cliques by taking reliable local collaterals. Since
legal reform is centered on making financial insti-
tutions robust in Asian countries, it seems they do
not think of promoting M&A using the chattel col-
lateral law like in the United States. It is because
M&A is means of reforming enterprises and not of
financial institutions.
In Central and East European countries, where
no local financial cliques are formed, finance to local
enterprises by offshore foreign-capital banks has not
proceeded except for finance to foreign-based enter-
prises, and instead the transfer of capital and man-
agement to foreign capitals is in progress by local-
capital banks that lack funds and know-how. Whether
both banks and enterprises are domestic- or foreign-
capital, legislation of the chattel collateral law means
supply of new collateral means. Especially, it will be
useful as financing means for newly established en-
terprises, domestic- or foreign-capital.

4. CHATTEL COLLATERAL LAW AND
BINDING FORCE OF LAW
(1) Degree of Adoption of Chattel Collateral Law
in Central and East Europe and CIS
On September 12 2000, Gerald Sanders, Legal Dept.
of the EBRD gave a lecture titled the “Legal Reform
Plan of EBRD and Collateral Law Project” at the Bar
Hall, Tokyo. As a commentator for his lecture, the
author spoke about the purpose of legislating the chat-
tel collateral law and the difference in use. Accord-
ing to him, the EBRD evaluates the degree of adop-
tion of the EBRD Model Law for Secured Transac-
tions in the zone into the following four classes.
Countries with excellent status: Bulgaria, Hungary,
Latvia, Lithuania, Poland
Countries with high degree of adoption: Albania,
Azerbaidzhan, Kirghiz, Moldova, Ukraina
Countries with low degree of adoption: Armenia,
Belarus, Estonia, Georgia, Kazakhstan,
Makedonia, Russia, Slovenija, Uzbekstan
Non-adoption countries: Czech, Slovakia, Croatia,
Bosna i Hercegovina
Rumania is excluded from this classification.
Rumania legislated the chattel collateral law in May
1999, but perhaps evaluation was not possible because
the collateral registration system was not established.
However, in the sense that the content of legislation
is almost the same as the Model Law for Secured
Transactions, it can be included in “Countries with
excellent status.” The country that interests us is
Czech and Slovakia. Among the countries where
market economy has proceeded and that have
achieved marked economic growth, there are coun-
tries like Czech and Slovakia where the chattel col-
lateral law is not adopted, as well as all the countries
with excellent status with regard to the degree of adop-
tion of the law.
Why does the market economy proceed without
introducing the chattel collateral law? One reason-
ing is a thought that financial transactions based on
7 Harvard Fund, a leading stockholder of Plzen Skoda, famous for the buying up of the privatized Voucher, appointed an excellent
manager from among the former management, and it led to successful operation. It can be said that the concept of the Velvet Revolution
in state system reform was also realized at the enterprise reform level.
JBIC Review No.4 31
the principle of market economy apart from the chat-
tel collateral law is realized in these countries. As an
aspect, many of enterprises that made investments and
have achieved success in Czech, both foreign-based
enterprises and domestic capitals, are small and
middle-scale enterprises, and since they did not need
to procure funds by bank loans, they could secure
capitals by using their own capitals or investments
from venture capitals. Large-scale manufacturers like
Skoda, too, does not need bank loans. Skoda Motors
were sold to Volkswagen, so there is no need of fund
procuration and no need of local collaterals. On the
other hand, Plzen Skoda, which originally was an en-
gineering enterprise does not need any large-scale fa-
cility investments and product stocks, could maintain
international competitive force based on the devalued
Czech crown (local currency of Czech) and high tech-
nological force, and since small-scale orders continue
to come overland from governmental and private cus-
tomers of the EU, they did not need finance.7
Since Slovakia succeeded in introducing foreign-
based manufacturing businesses based on the low-
cost, ample labor force, there was no need of local
finance. Material type manufacturing businesses,
including petrochemical, are formerly state-owned
enterprises. Since they were not divided, they secure
daily earnings using the pipeline. The Slovakia-capi-
tal enterprises that failed in military-private conver-
sion went bankruptcy, indeed, but the foreign-based
enterprises and successful privatized enterprises
worked as a driving force of economic growth well
covering the former.
Thinking this way, it seems that when an enter-
prise has a technological force and does not need any
large-scale facility investment, the chattel collateral law
is not always indispensable. However, perhaps it is
not off the point to assume that in the formerly social-
ist countries of Czech and Slovakia, transactions be-
tween enterprises and bank-enterprise transactions,
except for certain political items, were conducted based
on proper legal rules to an extent that legislation of the
chattel collateral law was not particularly required.
32 Chattel Collateral Laws of Bulgaria, Rumania and Hungary and Japanese Enterprises’ Business

(2) Legislation and Application of the Law
Since the chattel collateral is formed as the right of
pledge in Hungary and since provisions about the reg-
istration of the right of pledge and collateral execu-
tion are given as descriptions about the nature of the
right of pledge, legislation is made in the form of car-
rying out the legislation for revising the pertaining
19 articles of the 1959 Civil Code. The chattel col-
lateral law of Bulgaria is provided as the right of
pledge without transfer of occupancy, however, as it
also contains provisions about the registration of the
right of pledge and collateral execution, it is made up
as the 1996 Law on Registered Pledges, a separate
law comprising 48 articles. In Bulgaria, there was no
uniform civil code, and conventionally provisions on
collaterals were stated in the obligation and contract
law, which was announced in 1950 and largely re-
vised based on shift to the market economy. So, per-
haps there was no hesitation to formulate a separate
law combining a substantive law and a procedural law.
The Rumanian chattel collateral law is made up
with 104 articles as a legal framework relating to Part
6 of the 1999 Law on Promotion of Economic Reform.
Although there are a civil code and a commercial code
in Rumania, the former covering the right of pledge
and the latter the right of mortgage, the chattel collat-
eral law does not only replace these provisions on the
right of pledge but provisions of the law also precedes
laws on state registration and the civil procedure code
so far as chattel collaterals are concerned.
The reason why it is such a long-sentence law
containing 104 articles is that provisions of collateral
registration and execution, which normally provided
by government or ministerial orders, are also included.
It is quite interesting to know why it was necessary to
provide items this way. The author thinks that, when
the Rumanian state sector was to put the law into func-
tion, perhaps the World Bank and the EBRD gave
advice on legislation, placing importance on the ex-
clusion of possibilities of arbitrary use. The author
also learned that partly because of the legislative pro-
cess, the 1999 Law on Promotion of Economic Re-
form is generally called Law obliged by the World
Bank inside the country.
As Rumania has a large population among Cen-
tral and East Europe and took the independent course,
leaving the COMECON, under the Ceausescu sys-
tem, they have a full-set type industrial structure.8 So,
the Rumanian have an aspect that looks as if they want
to join the EU, leaving the domestic industry, as is.
The EU Committee has started negotiations for par-
ticipation, showing the Rumanian government leg-
islation/political measures for them to provide before
joining the EU, as acquis communautaire (reform
schedule). There the adoption of EU standards and
criteria as well as laws of market economy are said to
be important items of the reform schedule a . The
EU Committee positions the economic reform pro-
motion law, containing the chattel collateral law, as
an important law of market economy. The EU Com-
mittee seems to consider that the adoption of laws of
market economy will minimize the protective mea-
sures for the domestic industry.
The people who operate the Rumanian govern-
ment are mainly those who were formerly executives
of the Communist Party that replaced ex-president
Ceausescu, who probably opposed to a rapid intro-
duction of market economy. In the presidential elec-
tion of November 2000, the middle-left faction re-
gained the administrative power. Under the middle-
right government started in 1996, there was no dras-
tic replacement in governing group. In this sense,
Rumania may be an “excellent country” in adopting
the EBRD Model Law for Secured Transactions but
may be a “country with law degree of adoption” in
applying laws. Generally speaking, an attempt to let
those who execute laws and those who interpret laws
formulate a law that leaves no space of interpreta-
tion, the completed law is a long one.9

8 Because of this, Rumania is called an “India in East Europe.”

9 In this sense, legal reform in Asian countries after the Asian Currency Crisis contains many problems. Since legal advice is
given by paying respects as a sovereign states, the state sector tends to interpret it favorably to themselves. In an extreme case, the text
of a new legislation itself is opposed to the legislative intention. Having no goal like participation in the EU of Central and East
European countries, awareness to build up a legally common basis of market economy is low in Asia. The WTO can only prepare a
common basis by means of the legal system related to trade, and the APEC is a mere place of deepening mutual understanding.

(3) Binding Force of Law
About the power to actually function a law, many dis-
cussions are made in an academic field of legal phi-
losophy. A theory of legal philosophy, which the au-
thor thinks it appropriate in following the legal re-
forms of business laws in Asia and Central and East
Europe/CIS, is the theory of conative impulse in the
binding force of laws proposed by Häger Ström, a
jurist of Northern Europe, introduced by Setsuko Sato,
Professor, Aoyama Gakuin University.10 Häger Ström
argues as the law does not exert its binding force upon
the objective people merely by legislation. The law
does not have binding force unless a “consideration
that they should act according to the action patterns
stated by the law,” namely conative impulse is present.
The “binding force, though subjective, is an idea hav-
ing a commensurable language and common to com-
munity members who were inculcated socially formed
values.” When conative impulse is ready, the “bind-
ing force of the law is established with an extension
called inter-subjectivity, or joint subjectivity in the
community.” Since the idea of binding force is formed
with uniformity through a certain procedure in a state
where social formation is successful, it causes an il-
lusion that the idea of inter-subjective binding force
is an objective attribute that belongs to the law.” 11
Prof. Setsuko Sato argues that the legal sociol-
ogy of the norm by Häger Ström is a work to answer
the following question.12 “(I) A study about a ques-
tion: In a society of a certain time, what action pat-
tern and conative impulse are actually connected, or
were connected, and, what are social, political and
cultural factors that bring forth the connection?” ...
(II) A study about a question: Normally, an action
matching the connection of an action pattern and con-
ative impulse is performed actually.
However, ... after a careful consideration or re-
flectively, sometimes I give up realizing the action.
What are factors acting there?”
10 Setsuko Sato, Right and Obligation - Binding Force of Law, Seibundo, 1997
11 Quoted from *10, p.23-24.
12 Quoted, including the following, from *10, p.196-197.
13 As examples of the universal law, sometimes the Universal Declaration of Human Rights, the WTO Law, market economy laws
and the natural law are named, but these allow a contradiction “We are not yet ready to accept these because period and social conditions
are different.” This is what is called the discussion about the development stage of laws, which is to be discussed on a subject of “law
and development”.
JBIC Review No.4 33
Prof. Setsuko Sato says that such an opinion of
Häger Ström differs basically from the following opin-
ion. “... Obligation to tell the truth is universal. How-
ever, the universality can vary about the way it ap-
pears in each situation and by various factors, ... Hu-
man rights are universal, however, the realization can
vary by the difference in period and social conditions,
but the universality of human rights are not lost be-
cause of this ...”
The argument of Häger Ström, to the author,
seems to have much significance in that one can con-
sider how to let each positive law function, without
maintaining, for example, an opinion about Asia such
that “there is an Asia-like sense of value, Asia-like
development or a law peculiarity to Asia.”
Each country has a pride as a national state and a
sovereign state. They repulse when a foreign coun-
try or an international organization foists a law on
them, saying there is a universal law, even if it is a
law useful for the market economy.13 There, it seems
that international organizations like the World Bank,
the EBRD or the Asian Development Bank in giving
legal advice to member countries, indicate the im-
portance of establishing legal governance and intro-
duction, while showing successful cases of the same
law model in other countries. As the same law mod-
els, there are the Model Law for Secured Transac-
tions of EBRD and the Insolvency Law Guidelines
of the World Bank, and the World Bank held an inter-
national seminar about judicial reform with a theme
of governance of law in June 1999 and plans to hold
it each year for the future. However, “governance of
law” itself is the concept of the common law coun-
tries. Central and East Europe and CIS countries that
were formerly socialist countries, and the Asian coun-
tries excluding formerly governed by Britain and the
Philippines are not a common law country because
of governance by Spain before the United States be-
long to the civil code countries, they tend to interpret
34 Chattel Collateral Laws of Bulgaria, Rumania and Hungary and Japanese Enterprises’ Business
“governance of law” as “governance by statute law”
and deny creation of laws by courts.
By seeing what decomposition has the Model
Law for Secured Transactions of EBRD made in Bul-
garia, Hungary and Rumania, we can see the way the
conative impulse proposed by Häger Ström. It seems
that this will not only show the collateral transactions
in these countries but also give suggestions how busi-
ness can be successful, as a whole.
CHAPTER II
CHATTEL COLLATERAL LAW OF
BULGARIA
1. METHOD OF COLLATERAL AND OBJECT
OF COLLATERAL
(1) Pledge Right or Transferable Collateral
In the Law on Registered Pledge, the chattel collat-
eral law of Bulgaria, the pledge right is used instead
of the chattel collateral. There the setter of chattel
collateral is the pledgor and the setting of chattel col-
lateral is pledge setting. Hereunder, basically the term
the pledge right is used. In Bulgaria, Article 209 of
the Law on Obligations and Contracts states “A sales
with a repurchase clause shall be invalid.” Milanov,
a Bulgarian lawyer acting with this as an important
ground in Japan says “Article 209 of the Law on
Obligations and Contracts prohibits transferable
collaterals(fiduciary transfer) and provisionally reg-
istered collaterals, floating collaterals(floating mort-
gages) are not known, and reserve of ownership is
discussed in theories.”14 This should mean that the
pledge right applies because, as collateral means for
movable properties, there is reserve of ownership but
not the transferable collateral. Since the fact that the
transferable collateral is not recognized means that
the transferable collateral of liability is not recognized,
it goes to collateral registration as credit pledge.
14 Sergei Milanov “Legal System in Bulgaria,” NBL vol.496, p.42.
15 This is expected to come into question when taking the long-term electric power sales contract as collateral in the thermal power
generation BOT project announced in 2000. A long-term, specific nominative claim, it is a registered credit. Registration is valid only
for five years but can be extended, so as a result a long-term finance period can also be covered.
Obtaining an acceptance by notice for transfer of a
credit as collateral seems to involve an anxiety of
being judged as invalid.15
As a difference between the pledge right and the
transferable collateral, the former prohibits a pledge
forfeiture contract while the latter recognizes collat-
eral forfeiture. This can be taken as an understand-
ing that, since formally the ownership is transferred
to the owner of the transferred collateral from the time
it is set, in case the obligation is not performed the
owner of the transferred collateral may fix the own-
ership before the time of repayment. Whereas in the
case of pledge, the understanding is such that, since
the pledgor consistently hold the ownership, it is not
agreeable if the ownership moves to the
pledgee(pledge holder) due to nonperformance of the
pledgor before the due date of the time of repayment.
Prohibition of the pledge forfeiture contract is a tra-
ditional concept since the Roman Law and is pro-
vided in laws of France, Germany, Switzerland and
Japan, and Article 152 of the Bulgarian Law on Obli-
gation also provides the following. “A contract that
previously provides a provision stating that, by non-
performance of the obligation, the creditor either ob-
tains the ownership of the security or may get repay-
ment by a method other than that stated by the law.”
Since the provision is provided as a general rule com-
mon to both the pledge and mortgage, it means that
mortgage forfeiture as well as the right of pledge is
prohibited.
Article 37.1 of the Law on Registered Pledge
states as “The pledgee is entitled to sell the pledged
property two weeks after the statement for com-
mencement of foreclosure is recorded. If a sales is
not completed within six months, any other creditor
who has recorded a commencement of foreclosure shall
be authorized to sell the pledged property.” and Article
11 of the same law states as “In case the pledgor does
not perform its obligations under the pledge agreement,
the pledgee may demand performance before the debt

matures,as well as satisfy its claim from the pledged
property.” Since the pledgee gets only the right of
selling and not the ownership of the security, it can
be said that the conception of prohibiting pledge for-
feiture is observed. When a careful handling is de-
sired, one may let the debtor forfeit the benefit of terms
and advance the time of repayment (acceleration) and
then get the debt repaid from the security.
EBRD’s Model Law on Secured Transactions
also prohibits collateral forfeiture in Article 24.2,16
and states in Article 24.3.2 as “The chargeholder must
advise the the purchaser that he is transferring title to
charged property in the capacity of chargeholder.”
The attitude of the Model Law on Secured Transac-
tions cannot be along the concept of the transferable
collateral. And, taking into account the conative im-
pulse as to utilize the tradition and laws of the coun-
try under the influence of the Model Law on Secured
Transactions, Bulgaria introduced the chattel collat-
eral system, employing the pledge right and leaving
the transferable collateral as prohibited.
In Japan, a concept that prohibition of the pledge
forfeiture contract should be abolished on account of
the following is a popular view.17 If an expensive
pledge security is taken on account of a small debt, it
may be made void in violation of public order and
good morals; since collateral forfeiture is possible by
handling it as transferable chattel collateral, actually
an evasion of the law is recognized; since only the
liquidation type is recognized for the transferable
collateral by a judicial precedent, there is no prob-
lem; actually it is possible to evade the law by the
repurchase contract; in commercial transactions, the
pledge forfeiture contract is recognized by the express
statement; and pledge forfeiture is recognized for
pawnbrokers. It should be noted that these sorts of
concepts are not acceptable in Bulgaria.
(2) Pledgor and Pledge Security
The pledge setter is a merchant along the concept of
the EBRD, or one who is regarded as trader in the
16 Article 24.2 reads as “Any agreement entered into prior to delivery of an enforcement notice pursuant to Article 22.2 which
providesforthe transfer of title to charged propertyby way of sale by or to the chargeholder after delivery of the enforcement notice is
invalid.”
17 Koji Ohmi, “Collateral Security Law”, Kobundo, 1998, pp.77-80.
JBIC Review No.4 35
Law on Commerce.
The object of pledge covered by the law includes
(1) accounts receivable, uncertificated securities,and
chattel exclusive of ships and aircraft; (2) share of
equity in general and limited partnerships, with shares
or limited liability companies; (3) groups of accounts
receivable, of machines and equipment,of inventory
or materials; and (4)commercial enterprise (4I). The
pledge security, if not specified individually, is ac-
ceptable if it is specified generally, and can also be
one that is generated in the future (4II). When the
pledge right is an accounts receivable, the interest is
also included. The pledge right includes the processed
works, too.
That, by stating the pledge security generally, an
unspecified/future account receivable becomes a col-
lateral as the pledge right is stated expressly. And,
since pledge registration can be done, the provision
means borrowing is made possible by using a future
cash flow of the pledgor as collateral, namely LBO is
made available. However, speaking from the present
conditions in Bulgaria, this aims to supply finance to
newly-emerging enterprises and service businesses
having not physical collaterals. The collective col-
lateral, for which specifiability is required in Japan,
should be identified with a plate and the like, but this
is not necessary in Bulgaria.
As an example of objects that are not stocks/in-
vestment shares (but not (2)) and stocks/holdings/
debts ((1) uncertified securities), deposit credit and
trust benefit (that can be securitized) may be consid-
ered. An ordinary contract credit cannot be consid-
ered as the object of pledge under the law. Thus, re-
gardless of whether securities are issued or not, con-
tract credits that cannot be securitized are excluded
from the provision, and these credits are excluded
from the object of pledge registration. This differs
greatly from the Model Law on Secured Transaction
where contract credits that are available as money
credits can be collateral securities. Rights, such as
tenant right, mining right, concession (development
36 Chattel Collateral Laws of Bulgaria, Rumania and Hungary and Japanese Enterprises’ Business
right, rights), intellectual property right, know-how
and trade secret are not included in these categories
and cannot be registered as pledges. However, the
way to bring to pledge registration the money credits
generated from these as accounts receivable can be
considered. If a claim is transferable, it can be used
as a pledge (Law on Obligations and Contracts, Ar-
ticle 162), the pledge setting itself is possible. Also,
in Bulgaria, the mining right and concession are not
recognized as transferable and so excluded from the
object of the right pledge.18
Bearer securities like national/corporate bonds
that are regarded as movable collaterals are available
as collateral securities. Directed credits like the ware-
house securities/bills/bills of lading are excluded from
this category. This probably means that directed cred-
its, of which the credit is securitized and processed
by endorsement/issue of the security, may be pro-
cessed by occupancy and pledge endorsement to take
these as collaterals, and do not particularly need to be
registered as pledge. The provision of Article 163 of
the Law on Obligations and Contracts “A pledgor
must hand over to the pledgee the documents provid-
ing the pledged claim, if there are such.” is applied
to. According to the EBRD Model Law on Secured
Transactions, these fall under the object of the pos-
sessory chargel that need not collateral registration.
Article 10.2 of the Model Law on Secured Transac-
tions states that at any time while possession as re-
ferred to in Article 10.1 continues a possessory charge
may be converted into a registered charge by regis-
tration in accordance with Article 8.2. It seems that,
in Bulgaria, ordinary movable properties of which the
pledge right is established by occupancy can be pledge
registered as (1), while the directed credit that is not
an ordinary movable property cannot but be met by
occupancy and pledge endorsement so as to set the
pledge right. The Japanese Bills of Exchange and
Promissory Notes Law provide pledge endorsement,
but it is seldom used, and mostly the transferable col-
lateral is used.19
To take an insurance money as collateral in Bul-
18 Explanation by lawyer Gouginski (Djingov, Gouginski, Kyutchukov & Velichkov Law Office) with whom consultation was
made there. Incidentally, the concession law was legislated in 1995 in Bulgaria, and the law has been revised almost every year.
19 “2500 Lectures about Legal Measures at Bank Window (Part II)”, Financial Affairs Research Group, 1993, p.603.
garia, generally a method to set the creditor as the
beneficiary is applied to. The method to pledge reg-
istration for the claim right of insurance money as
accounts receivable is not used, and the method to
transfer the insurance note(certificate) as collateral is
not employed as it might offend against the prohibi-
tion of collateral forfeiture. Both in Japan and Bul-
garia, the commercial codes let the insurer reserve
the right to designate/change the beneficiary, without
the beneficiary’s consent, with declaration of a par-
ticular intention. To cope with this, both in Japan
and Bulgaria, practically a special contract is ex-
changed so as not to change the designated benefi-
ciary without the consent of the creditor and the credi-
tor holds the insurance note(certificate) so as not to
allow endorsement to change the beneficiary.
(3) Utilization of Enterprise Collateral Right
A commercial enterprise itself is taken as collateral
(4), is a provision recognizing the enterprise collat-
eral right. EBRD Model Law on Secured Transac-
tions also recognized the enterprise charge to take the
entire of corporate assets. In Japan, setting of the
enterprise collateral right can be used as collateral in
issuing corporate bonds (Japanese enterprise collat-
eral law, Article 1). However, both the EBRD and in
Bulgaria, the enterprise collateral (pledge) is consid-
ered as collateral of ordinary bank finance. And, as
method of collateral execution, it is allowed to sell
out the whole enterprise as continuing enterprise, or
sell individual assets of the enterprise (46, Model Law
on Secured Transactions, Article 25.1). In Japan, the
enterprise collateral right holder only precedes ordi-
nary unsecured creditors and is subordinate to all other
secured creditors (Japanese enterprise collateral law,
Article 2). To precede the pledgees of individual cor-
porate assents, these individual assets may be listed
up in registering the enterprise collateral right (21 III).
Then, the relative priority is fixed by the order in pro-
viding requirements for setting up the pledge right
on individual assets and in registering the enterprise
collateral. The financier may choose the enterprise
 JBIC Review No.4 37

collateral rather than the accounts receivable collat-
eral. However, when executing the enterprise collat-
eral, selling as continuing enterprise will not be easy
without a brand/technological force and the collat-
eral execution needs an enterprise administrator and
the cost. Also, as the enterprise collateral is not
enough to check the cash flow, in collateral execu-
tion, selling of individual assets will be preferred to
selling of a continuing enterprise. It seems, as a pos-
sibility, the enterprise collateral will be used for fi-
nancing to an enterprise having huge fixed assets or
inventory assets or for issuing the corporate bond of
such an enterprise.
Yasunobu Sato etc. recognize the significance of
the enterprise collateral as “With regard to the project
finance used for the PFI and others, a collateral cov-
ering a whole enterprise has become recognized as a
necessary legal technique.”20 The author thinks that
for a project finance like electric power, water and
railroad projects of which users of credit sales are
specified by the long-term sales contract, a combina-
tion of collateral registration of accounts receivable
and mortgage registration of real estate to land and
buildings is preferred to enterprise collateral regis-
tration. Because, more strict assessment of the cash
flow is desired, and specified collateral securities can
easily be supplied as collaterals or securitized. For
projects such as roads, bridges and parks, of which
users of credit sales are unspecified, use of the enter-
prise collateral can be considered. Especially, as it is
difficult to set the mortgage right to public roads, it
seems the use of the enterprise collateral can be more
effective.21
When individual assets are listed up in an enter-
prise collateral contract, relevant assets even after
separated continue to be the object of the enterprise
collateral right (21 III, latter paragraph). This is a
provision confirming that the object of collateral is
transferred with the collateral right. Even when a
pledge security is transferred, it is accompanied with
the pledge right. However, when an appendage on a
mortgager security is transferred, the mortgage right
does not accompany. Since some enterprise collaterals
include real estate, this is considered a confirmation
provision to prevent claims about limits due to the
nature of the mortgage right. For example, machin-
ery/equipment of a plant, as a collateral security of
the enterprise collateral right, is often subject to sepa-
ration. In the ordinary pledge right, when an append-
age is separated from the objective real estate, the
effect of the mortgage right is not exerted on it. This
can be assumed as an effect that, with regard to the
enterprise collateral right, the enterprise collateral right
extends by listing up the machinery/equipment of the
plant, if separated. In Japan, too, the Plant Mortgage
Law provides the same context in Article 5.1.
(4) Collateral Credit
The collateral credit, when specified as a whole credit,
is acceptable both individually and altogether, and
even a future credit, a credit on a condition that a
certain condition is satisfied is also acceptable (5 (1)).
Since no restrictions are given to the collateral credit
in pledge registration, pledge registration can be made
by taking as pledge security a real estate currently
present for securing a credit that is not yet generated
or a currently present pledge right. Registration of a
fixed pledge is recognized. In addition, pledge regis-
tration, taking as pledge security an unspecified fu-
ture credit that is not generated yet can be pledge reg-
istered as security for a collateral that is not gener-
ated yet, is possible, too. Since pledge registration as
to finance a purchase fund, taking an unspecified fu-
ture account receivable of the debtor as collateral, is
recognized, this means to facilitate LBO.22
“Registration items of the collateral credit are the

20 Yasunobu Sato etc.,EBRD - Introduction of Model Collateral Law and Commentary, NBL, Aug. 15, 2000, p.70.
21 Also, possibly the enterprise collateral right will be used for BOT project issuing US 144a bonds.
22 However, there is no provision stating “The collateral notice can be registered even when the collateral contract is not yet
concluded and the collateral right is not established yet.” like US UCC Article 9-402. Whether or not more than one purchaser appear
and increase the purchase price through collateral registration, like the LBO competition of the United States, will depend on the
practical business of registration. Although making pledge registration without any pledge setting contract is ineffective, the collateral
credit can be specified even if the contract date column of the collateral credit is left blank in the registration form, and in Article 26
providing items of registration, entry of the date of pledge setting is not required, so it seems checking is not possible.
38 Chattel Collateral Laws of Bulgaria, Rumania and Hungary and Japanese Enterprises’ Business
content or the amount of collateral credit” (26 I (2)),
so in case of the fixed pledge, entry of a limiting
amount is required. For other cases, however, the
amount of collateral credit may be left unfilled if only
it is specified. Also, when the collateral credit is large
while there is more than one pledge security, it is
meaningful to enter the amount of collateral credit.
With regard to the form of the notice of pledge regis-
tration, there are items, including the title and date of
collateral credit contract, the content and interest, and
entry of the effect and the amount of collateral credit
if the credit is taken as collateral for another case.
Normally the notice may be given by stating the
amount, but following the provision of this article,
probably registration of the notice is not rejected even
if the amount is left unstated.
In addition to the principal of the collateral credit,
the amount may also include amounts of interest and
penalty (5 (2)). In Japan, the scope of collateral credit
is the total amount of interest and delay damages in
case of the pledge right, and the last two years of the
same in case of the mortgage right. The Bulgarian
Obligation and Contract Law, Article 174 provides
that when the mortgage right is registered, the last
two years of the interest are added to the collateral
credit, and Article 172 provides that the effective pe-
riod of registration of the mortgage right as 10
years,taking more strict attitude to the creditor of
mortgage right than in Japan. As the reason of limit-
ing to the last two years “It is meaningful to make
known the collateral frame of the currently set mort-
gage right and at the same time raise the use of re-
maining value of the mortgage object.”23 Although
making the registered pledge right unlimited will
cause inconvenience to the subordinate pledgers in
setting their collateral frames, probably their under-
standing is such that it cannot be helped since there is
no legislation restricting the scope of collateral credit
of the pledge. The idea of two years about the mort-
gage right originates in the French law and it is not
provided in the German law. In Japan, too, no con-
sideration is required about the collateral frame when
23 Koji Ohmi, Collateral Right Law (new edition), Kobundo, 1998, p.145.
24 23, p.145.
there is no subordinate pledgers, the understanding
that the interest and penalty can be charges in full is
commonly accepted.24
2. ESTABLISHMENT OF PLEDGE RIGHT
AND SUBSTANCE OF THE PLEDGE RIGHT
(1) Setting of Pledge Right
The setting contract of the pledge to be registered must
be made in writing (2). In Japan, this is not neces-
sary. The unpaid seller collateral right, when there is
a nonpayment period of 14 days and longer and when
the object of sales is included in the collective mov-
able collateral if not pledge registered, it cannot cope
with the collective pledgers who made pledge regis-
tration earlier. So, for the seller to obtain the
counterforce, the pledge setting contract should be
concluded in writing. It is advisable to prepare a writ-
ten sales contract & pledge setting contract, includ-
ing the provision about the unpaid seller collateral
right. In Japan, this question is discussed as the rela-
tive priority between the preferential right of mov-
able properties and the collective transferable collat-
eral, and there are three standpoints: (1) The judicial
precedence in Japan takes it that since delivery by
occupancy revision is allowed with regard to the trans-
ferable collateral, the transferable collateral creditor,
a third acquirer, cannot press the preferential right
holder, namely the transferable collateral precedes;
(2) Civil law authorities like Rokuya Suzuki and Eiichi
Hoshino recognize the immediate acquisition of pref-
erential right and support the priority of the preferen-
tial right; and (3) Influential scholars of civil law like
Koji Ohmi and Kiyoe Kaku see that the transferable
collateral and the pledge right are ranked the same
and the preferential right falls behind the pledge right,
and support the priority of transfer.
EBRD Model Collateral Law states in Article 6
as requirements for the establishment of collateral
right, preparation of the written collateral setting con-
tract, collateral registration for the registered collat-
eral right, and occupancy for the occupied collateral

right. Bulgaria, does not take a concept like this and
instead takes a composition of the traditional, estab-
lishment of the right, effectuation of the right, and
the counterforce. Perhaps it is more easily accepted
since this way conative impulse works on the use and
application of laws. Establishment of the pledge right,
in the registered pledge right that corresponds to the
registered collateral right, is by preparation of the
written contract, and in the chattel pledge right corre-
sponding to the occupied collateral right, the agree-
ment of pledge setting. The requirement for effec-
tuation of the pledge right is delivery of the pledge
security, and in the credit pledge, delivery of the cer-
tificate (Obligation and Contract Law, Articles 156
and 163, Pledge Registration Law).25 The require-
ment for the registered pledge right to effectuate is
the notice to the debtor in the account receivable, reg-
istration to the Central Depository in case of securi-
ties without issuance of the securities, and registra-
tion to the Commercial Register for stocks and the
enterprise collateral right. And, counterforce require-
ment of the pledge right is the written contract of
pledge setting in the case of a chattel pledge, the no-
tice to the debtor for a nominative claim (Obligation
and Contract Law, Articles 156.2 and 162), and reg-
istration to the Central Pledge Register under the
Pledge Registration Law (Article 12). In the Obliga-
tion and Contract Law, there is no provision about
the counterforce about the credit pledge of other than
the nominative credit.
Since this law provides a pledge right set with-
out moving occupancy (1), a change is made to the
security requirement for the pledge right. There are
two types of pledge right, one that obtains the
counterforce by occupancy and the other the obtains
the counterforce by pledge registration. The security
requirement is met by occupancy of the pledge secu-
rity. Since pledge registration itself is the counter
requirement, it is not directly related with the secu-
rity requirement of establishment. However, pledge
setting of a pledge security that obtains the
counterforce by pledge registration needs a legal a
certain action to replace occupancy so that the secu-
25 The pledge Registration Law is applied to only when the pledge setter is a trader, and the credit pledge set by others than the
trader is covered by the Obligation and Contract Law.
JBIC Review No.4 39
rity requirement can be met. The Pledge Registra-
tion Law also observes the provisions of Article 156.1
of the Obligation and Contract Law stating “When a
movable property is taken as pledge security, the
pledge setting contract has not effect unless the pledge
security is delivered to the creditor or another person
nominated by the creditor and the pledge setter,” and
of Article 161 thereof, stating “rules provided in this
chapter that are related to the setting and effect of the
pledge right shall not be abolished by a different pro-
vision of another low.” However, an interpretation
such that “this chapter” stated in Article 161 refers to
only the rules related to the chattel pledge provided
under Articles 156 to 161 and not Articles 162 to 165
containing provisions about the credit pledge, is also
possible. It is because, in the composition of the
Obligation and Contract Law, this chapter is posi-
tioned in Introduction, Collateral of Part 7 Credit
Collateral, Chapter 4 Pledge Right and Mortgage
Right, Section B Chattel Collateral, Section C Credit
Pledge and Section D Mortgage Right. Author does
not agree to this interpretation, because, though “this
chapter” directly refers to the chattel pledge, apply-
ing it as the principle of pledge right as a whole make
the law a positive law that will more easily evoke the
conative impulse proposed by Hega Strame.
In the account receivable, the pledge right is set
when the pledger or pledge setter notices the debtor
of the pledge setting (17). In securities without secu-
rity issue (the stock/holdings/debt referred to in Ar-
ticle 4.1), pledge registration is to be made at the
Central Depository (18). That is, pledge registration
is required in addition to pledge registration at the
Central Pledge Register. The pledge setting contract
must be notarized about signatures and registration
about the stock pledge in the Commercial Register
(19). The enterprise collateral right must be notarized
about the signatures of the setting contract and regis-
tered about the enterprise collateral in the Commer-
cial Register (21). Registration to the Commercial
Register is the setting requirement and registration of
the enterprise collateral right at the Central Pledge
Register is the counter requirement. Registration as
40 Chattel Collateral Laws of Bulgaria, Rumania and Hungary and Japanese Enterprises’ Business
setting requirement is to satisfy the security require-
ment, and registration at two places is because the
chattel collateral right is composed as a pledge right
and not a transferable collateral.
In the case of ordinary movable properties, the
pledge right can be set without occupancy, and regis-
tration of the pledge right, as counterforce, is required
(4 I 1). Oppositely speaking, this means that when
the pledge right is set by occupancy alone, pledge
registration as counterforce is not necessary. Conse-
quently, the only legal action replacing occupancy, in
the case the pledge right is set without occupancy, is
the written contract of setting. Though eased, this
opposes the concept requiring the security require-
ment. To make a reasonable explanation on condi-
tion that pledge setting by occupancy revision is not
recognized, it is limited to certain cases, including
the case in which delivery is recognized in the form
of taking an object kept at the third party, as is, as the
pledge security. However, there are no such provi-
sions. This seems a biggest problem in matching a
foreign chattel collateral system with the conventional
pledge right.
Practically, pledge setting without occupancy will
be limited to the case the pledge setter has a reason
not to apply occupancy. A subordinate pledger is the
typical case. If the use about this point is left without
being clarified by a rule, attempts to make pledge reg-
istration, regardless of occupancy or not, will increase
in the practical business. Perhaps concern to a con-
cept of pledge setting by delivering occupancy will
be lessened, and rather pledgers who try to make
pledge registration even for movable properties of
which the pledge right is set by occupancy, will ap-
pear. This may be favorable to the state sector in that
it will increase fees of pledge setting and reduce make
ups from the state budget to pledge setting business,
but for the enterprise sector this may cause compli-
cacy in business procedures.
(2) Pledge Right and Transferable Collateral
Right
When the pledge setter has a ground to continuously
26 *11 p.75.
27 *11 p.284-285.
occupy the pledge security, it is not because delivery
was made by occupancy revision but there is pledge
registration. In this sense, it can be said that the con-
cept of Japan, Germany and France that does not rec-
ognize pledge setting by occupancy revision is main-
tained.
In Japan, when the pledger returned the pledge
security arbitrarily to the pledge setter, opinions (1)
the pledge right extinguishes, and (2) only the
counterforce extinguishes and the pledge right does
not are opposed to each other. (2) takes the transfer-
able collateral as (pledge setting + occupancy revi-
sion), and maintains that once the transferable collat-
eral is approved, an interpretation that the pledge right
extinguishes when the pledger loses occupancy breaks
the balance.26 Koji Ohmi, interpreting that the trans-
ferable collateral originally takes the form of repur-
chase + lease and it is named this way when trans-
ferred as collateral,27 denies opinion (2).
According to the concept of Bulgaria that does
not recognize a transferable collateral, opinion (2)
seems appropriate. For Bulgaria’s denial of the trans-
ferable collateral, a time-honored explanation is also
possible, saying as they have passed through the times
of socialism when the announcement function was
made important and occupancy revision could not
perform the announcement function. The Obligation
and Contract Law states in Article 159, consistently
from before the big revision of 1993, as “The pledger
obtains the priority to receive repayment from the
pledge security by compulsory execution on condi-
tion that the pledger will not return the pledge secu-
rity of the chattel pledge to the pledge setter. If the
pledge security is under occupancy of the pledge set-
ter, it is regarded as the movable property is returned.”
Also, Article 162 of the same law provides that “The
setting contract of the credit pledge cannot cope with
the third party unless the debtor know the pledge set-
ting.” A clear-cut opinion about the counter require-
ment, it is considered a provision supporting opinion
(2).
This pledge registration law also contains pro-
visions like the following: Even when collateral credit

C that covers, as pledge security, collateral credit B
that covers A as collateral exists, the pledge setting
contract between A and B remain in effect (6); When
the third party gets a pledge security transferred from
a pledger in the normal business process and the third
party acquires a right, conflicting with the pledge
right, to the pledge security, the pledge right extin-
guishes (7). Article 7 is to the effect that, when a
collective object like a stock is taken as collateral,
and when the stock is partially discharged/added to,
as merchandise, by trade, the purchaser obtains mer-
chandise on which no pledge is set. However, from
these two statements, it seems that a principle that
the substance of the pledge right is the security re-
quirement, since the pledge right does not extinguish
by occupancy as pledge right (though the security
requirement is eased) but extinguishes by transfer of
occupancy by ownership.
By considering that the substance of pledge right
is the security requirement and the substance of trans-
ferable collateral is (pledge setting + occupancy revi-
sion), the pattern of a universal action of collateral
becomes clear to an extent, and the conative impulse
proposed by Hega Strame, that people who are to
newly use the system want to use it with understand-
ing, sees the light. We should not give us as, “Since
social conditions differ by countries, universality of
collateral will appear differently,” and seek “What are
the social, political and cultural factors that combine
the pattern of an action of collateral and conative
impulse?”
(3) Conative Impulse, Pure Jurisprudence,
Possibility of Counterevidence and Business
Method
Kelsen established pure jurisprudence as a method to
grasp the substance of positive law, but it exclude all
righteous ideology and argues as “What is important
to jurisprudence is to systematically develop various
possible hypotheses and think them out in terms of
28 Koji Takahashi, Method and Structure of Kelsen Jurisprudence, Kyushu Univ. Publishing Association, p.121-122.
29 * 18 p.151.
30 *10 p.34: Thinking of the ownership by replacing it with the pledge right or the transferable collateral right is the author’s
application.
JBIC Review No.4 41
consistence from all aspects.” 28 About whether or
not this approach can obtain understanding of people
who actually use laws, it seems the theory of legal
order is inevitably required. Because of this, as a prin-
ciple to overthrow the generally spoken “A bad law
is also a law,” the natural law, a visionary discussion,
is inevitably required. Kelsen had to say “The meta-
physical discussion of justice ... is scientifically a “lie”
..., however, politically it is a “useful lie.”29 The con-
tradiction, an “effective lie,” by the natural law is ef-
fective for a state infringed on human rights like Na-
zis, Germany, indeed, but it will lose all when refuted
as being a subjective value judgment. As an approach
to press the principle of business law, which is often
seen as a “question of decision, after all,” the approach
by the North European realism jurisprudence by Hega
Strame, which is not a natural law nor pure jurispru-
dence seems effective.
Also, in addition to the principle of business law,
the approach of North European realism jurispru-
dence seems to be applicable, to an extent, to proce-
dural laws such as the procedure law and to the
theory of governing organization covered by the con-
stitution. It should be noted that reasoning the hu-
man right theory under the constitution by the prin-
ciple of natural law makes difficult contradiction to
expressions like a development stage as to discuss
such human right protection has not been reached
yet.
Häger Ström reckoned that universality itself is
like religion and puzzled the jurists who looked upon
jurisprudence as science. According to Hega Strame,
“A right called the ownership is a mysterious power
to the object, and what creates and transfer this mys-
terious power ... is a sorcery act.”30 However, the
argument that the opinion that “The ownership should
be protected” is true is doubtful. Being unscientific
without any possibility of counterevidence has already
been proved by Carl Popper. Being unscientific does
not need to abandon the effort of finding a scientific
42 Chattel Collateral Laws of Bulgaria, Rumania and Hungary and Japanese Enterprises’ Business
truth. Bertory, a critical rationalist like Popper,
mentions, as a method to criticize opinions and sup-
position, compatibility, contradiction by sensory
observation, inconsistency with a scientific theory,
and problem solution.31 And, as a method of prob-
lem solution, he mentions the principle of bridg-
ing for connecting a value and a fact. The prin-
ciple of bridging is “When execution of a moral
order legal order (or moral order) is impossible or
difficult, obligation is reduced/remitted.” The au-
thor thinks that whether or not the text does not
make people feel the execution of legal order im-
possible/difficult and instead generates a conative
impulse as to make them feel like following the
legal order, is the legislation and interpretation of
business positive law.
3. REGISTRATION OF PLEDGE RIGHT
AND THE RIGHT/OBLIGATION OF
PLEDGOR
(1) Registration of Pledge Right and Counterforce
The counterforce to the third party is realized by
pledge registration in the case of the pledge security
provided by this law, and for pledge securities other
than those provided by this law, by occupancy by the
pledger or by separate registration. That is, of things
called the credit pledges, nominative national bonds,
nominative corporate bonds, unsigned national/cor-
porate bonds and endorsed directed securities cannot
cope with the third party unless the pledger occupies
these. Pledge registration is not needed. Ships and
aircraft are occupied by the pledge setter, but the
pledge setter cannot cope with the third party with-
out registering the pledge right in the register of the
ownership. Since this law does not have provisions
to the effect that a pledge right given the counterforce
by occupancy can be changed to a pledge right hav-
ing counterforce by pledge registration, what is the
pledge security by occupancy is important. EBRD
Model Collateral Law has a provision stating that an
occupied collateral right can be changed to a regis-
tered collateral right whenever during the occupancy
period (Article 102).
31 Yasuyuki Kageyama, Conception of Critical Rationalism, p.247
Of the pledge securities provided by Article 4 of
the law, ordinary movable properties and stocks with
security issue, as occupied by the pledge setter, en-
ables the pledger to cope with the third party by pledge
registration. Even when the pledger can obtain occu-
pancy by the pledge right, occupancy is not required
but pledge registration is necessary. The reason the
author thinks that pledge registration will increase
more irrespective of occupancy or not, is because
pledgers who think the occupancy of pledge right is
troublesome not only deposit it to the third party but
they will also come to think they may leave it at the
pledge setter.
With regard to collective accounts receivable,
collective machinery/equipment and stock/raw ma-
terials, the pledger can cope with the third party by
pledge registration, with these being left occupied by
the pledge setter. While the pledgor does not need to
take any specifying method, unlike the collective
transferable collateral in Japan, pledge registration is
necessary. For accounts receivables, securities with-
out security issue (deposit credit and trust benefit),
stocks/equity holdings without security issue and en-
terprises, occupancy is not applied to because of their
nature, while the pledgee is required to make pledge
registration. For industrial property rights, copyrights,
know-how, trade secrets, etc., when composed as ac-
counts receivable thereof, the pledgee can cope with
the third party by pledge registration.
In an enterprise collateral right setting contract,
the secured enterprise creditor, when stating the list
of individual assets, can exert the pledge right even
after the listed assets are separated from the enter-
prise, but otherwise the pledge right cannot cover
these separated individual assets (21).
Priority between multiple pledgees of the same
pledge security follows the order of pledge registra-
tion (14).
(2) Unpaid Seller Collateral Right
Article 12 of the law further provides that for trades
with ownership reserve, lease contracts and attach-
ment of properties: made to secure execution to prop-
erties because of money debts, Law on Obligations
 JBIC Review No.4 43

and Contracts Articles 180-182), too, the pledgee can-
not cope with the third party without pledge registra-
tion. A typical example of the trade with ownership
reserve is installment sales, and as an item that per-
forms the same function, the unpaid seller collateral
right can be mentioned. The ownership is not trans-
ferred in the case of ownership reserve, while it is
transferred in the unpaid seller collateral right. As
the unpaid seller collateral right provided by Article
9.1 of the EBRD Model Law on Secured Transac-
tion, there are (1) trade with ownership reserve of
movable properties and (2) written agreement to ac-
quire the right to secure a collateral between the par-
ties of trade. However, only the trade with owner-
ship reserve is provided in Bulgaria. Article 205 of
the Law on Obligations and Contracts only provides
that the trade with ownership reserve is available for
installment sales. The collateral referred to in (2) is
probably the case the registered pledge is applied to
instead of the occupied pledge in ordinary chattel
pledges.
When the seller of raw materials has made pledge
registration before the completion of sales payment,
the pledge right can be executed to the processed
movable property by applying Article 4.4 of the law.
Even when the bank has pledge registered collective
stock merchandise, when the materials supplier has
pledge registered the ownership reserve, the materi-
als supplier get priority payment from the pledge se-
curity.*32 Since normally the value by processing is
considerably above the value of materials, normally
the processor has the ownership of the processed
work,*33 it should be noted that another case is gen-
erated by the pledge registration of ownership reserve.
As there will be many parts supplying enterprises
among the Japanese enterprises launching in Bulgaria,
the pledge registration of ownership reserve will be
an important method of credit collection from Bul-
garian enterprises.
Unless the pledge registration of ownership re-
serve is made within 14 days of the contract, when
the pledge security is included in the collective stock
of the buyer, the pledge registration of the collective
stock pledge right cannot precede the pledgee (15).
The same applies to the right of a lessor (15 II). The
time of ownership reserve and the pledge registration
by lessor can be anytime, but to cope with the regis-
terer, within 14 days is required. In the case of the
registered pledge of (2) above, probably immediate
pledge registration is necessary to cope with the reg-
isterer of collective stock collateral. When a com-
pany has already taken the vehicles and office equip-
ment that an enterprise uses as collective collateral at
a financial institution together with pledge setting,
and when a leasing company newly leases the ve-
hicles and/or office equipment like PC thereafter,
pledge registration of the lease must be made within
14 days to cope with the financial institution.
Article 9.3 of the EBRD Model Law on Secured
Transactions states that an unpaid seller collateral right
can be converted to the registered collateral right by
collateral registering within six months. In Bulgaria,
it is discussed when the buyer or lessee included per-
taining merchandise in collective objects and pledge
registered for another party. This means that when
the seller/lessor has confirmed no registration of col-
lateral pledge right in the pledge register, it is not nec-
essary to immediately pledge register the ownership
reserve. However, considering required registration
period is 14 days it seems advisable for those who
sell/lease durable consumer goods/equipment to take
the management policy “to uniformly pledge register
ownership reserve” to avoid unnecessary troubles.
Because, the provision about the 14th day may be
legislated conveniently to the buyer/lessee.
A situation that due to delay in pledge registra-
tion, the sold object cannot be collected because the
collective pledge right has already been set at time of

32 Koji Ohmi, Collateral Security Law, p.302 introduces that this problem caused a political issue of transferable collateral in
Germany of early 20th century and the cases not used so much in Japan.
33 Article 246 Proviso of Japanese Civil Code, descriptions about German civil code, Akira Yonekura, Study of Ownership Reserve,
p.69, 84-91. Yonekura proposes as “Since this is a legally technical provision of solving disputes between processors and materials
holders, it should be understood that the agreement, if any exchanged between the two, precedes.” In Bulgaria, the processor must sign
as pledgor to get the pledge registration recognized, their standpoint can be said to be the same as Yonekura’s.
44 Chattel Collateral Laws of Bulgaria, Rumania and Hungary and Japanese Enterprises’ Business
the actual nonperformance of debt, can be well con-
sidered. The period of six months stated by the Model
Law on Secured Transactions has the reason, because
many Ls/C cover three to six months. However, the
period of 14 days is too short and rather indicates a
legislative intention. In Rumania where the Model
Law on Secured Transactions was referenced in leg-
islation, a clear-cut statement is given to the unpaid
seller collateral right holder and one who supply the
loan for purchase, saying that they cannot precede
another chattel collateral registerer unless they make
collateral registration before the start of occupancy
by the debtor.
(3) Right and Obligation of Pledgor
Since the pledgor under the law continues to occupy
the pledge security by easing of the security require-
ment, so the pledgor undertakes an obligation similar
to that of the mortgagor. Besides (1) the general ob-
ligations stated below, the pledgor undertakes obli-
gations (2) to respond to an inspection of the pledge
security by the pledgee; (3) to register the transfer of
right related to the pledge security; (4) not to dispose
of the pledge security after receiving the notice of
pledge execution; and (5) to undertake the obligation
to extinguish the pledge right by repayment to the
pledgee (9). In (1), obligations include insurance,
notice when the pledge security gets damage, notice
to the pledgee about the transfer of rights related to
the pledge security, and selling of the perishable
pledge security. As the pledgor is a merchant, the
pledgor undertakes the duty of the diligence of a good
manager as trader. When the right is transferred as in
(3), setting of subordinate pledge right, disposal of
the pledge security with the pledge right, and a change
in style due to processing may be included. When
the obligation is neglected, the pledgee can execute
the pledge right prior to the term.
The right of pledgor includes the right of occu-
pancy and use and the right of disposal (8). Since the
right of disposal is considered to include also the right
to transfer the pledgee security, in this case the pledge
security is transferred together with the pledge right.
When the pledgee does not want transfer or another
pledging of the pledge security, the pledgee cannot
cope with the third party without making pledge reg-
istration to the effect that there is a special agreement
prohibiting transfer and/or pledging. The Japanese
civil code provides subpledging, but whether the
subpledging that the pledgee does pledging without
obtaining the consent of the pledgor is within the scope
of the provision becomes an issue, because the
pledgee, who does not have a disposal right of own-
ership, occupies the pledge security. However, the
law has no provision about subpledging. Since the
law provides that the pledge right is set with the pledge
security left occupied by the pledgor and the pledgee
cannot move the occupancy by subpledging, there
seems no provision about subpledging. On the other
hand, taking a pledge security that the pledgor occu-
pies based on the ownership, without getting the con-
sent of the pledgee, as a collateral of the pledger is
quite natural. Thinking this way, in Bulgaria the
pledgee needs the consent of the pledgor to supply
the pledge security for the pledge right of another
pledgee.
Taking a credit accompanied with a special agree-
ment prohibiting transfer seems practically impos-
sible. Since pledge registration is made, the pledgee
cannot say that he/she does not know that transfer is
prohibited. In Japan, credits to government agencies
are accompanied with the special agreement prohib-
iting transfer, and receipt as agent and deposit desig-
nation is used, while in Bulgaria it seems enough to
obtain the consent about pledging from the govern-
ment agencies as third debtor. Because, they can ex-
plain to the government authorities that the enterprise
sector of Bulgaria will not grow without making the
most of the chattel collateral law.
(4) Right and Obligation of Pledgee
The pledgee has the right to receive appropriation of
the collateral credit either from: (1) the price of the
pledge security or the substitute of the pledge secu-
rity; (2) the sales amount obtained by transfer of the
pledge security; or (3) (1) or (2) whichever is equiva-
lent to the pledge security (10). Since the use right of
the pledge security exists in the pledgor, in the case
of the credit pledge, the interest and/or principal of
the pledge security cannot be applied to repayment
of the collateral credit. Article 164 of the Law on
Obligations and Contracts provides as “The pledgee

undertakes the obligation to collect the interest and
principal of the creditor, and the collected interest and
principal must be kept as pledge security. When the
collected object is cash, it must be deposited as pledge
security in the bank.” Collection from the debtor is
not a right but the obligation of collateral preserva-
tion.
4. REGISTRATION OF PLEDGE RIGHT
(1) Pledge Registry and Registration Fee
The entity that deals with the business of pledge right
registration is the Central Pledge Registry, a corpora-
tion located in Sophia. It was installed by the Minis-
try of Justice, the president is appointed by Minister
of Justice, and operating expenses are paid by the state
budget (22). Everybody can has access to the regis-
tered content and can obtain the certificate about the
presence or not of pledge registration (24).
Fees are set by the Cabinet, about which some
may think exaggerated. However, if the fees are set
too high, those who do not want to pay fees do not
use the pledge registration system. In order for the
system to be actually used, it had better be kept free
from the Ministry of Justice that governs the system.
Since generally discussions like: ministers of govern-
ment agencies relating to business request to set fees
at a low level; Minister of Justice asserts a practical
maintenance cost; and the Prime Minister’s Office
thinks of support to the maintenance cost from the
budget, taking into account restrictions on the state
budget, can be made, the provision is set in expecta-
tion that fees are set at a proper level.
(2) Items of Registration
In an application for registration, items of the agree-
ment between pledge setter, buyer in installment and
lessee to be registered by authenticated signature are
the following: (1) Name, identification certificate
number (commercial register number) and address of
the debtor, third party pledgor, pledgee, trade parties
of in ownership reserve, parties of the lease, and the
collecting agent of account receivable; (2) indication
of the collateral credit or the amount of collateral
credit (it seems the upper limit of the collateral credit
is not required and that entry of the amount of collat-
JBIC Review No.4 45
eral credit on foreign currency is also accepted); (3)
the pledge security, and the amount of the pledge, if
indicated (as a pledge security indicating the amount,
the case of taking a specific account receivable as
pledge security can be considered, but the evaluated
amount of the pledge security is not required); (4) the
period of registration (5 years at longest, but can be
shorter); and (5) conditions of registration, if any.
The form of the notice of pledge registration is
prepared in English, too, so it seems pledge registra-
tion in English is also acceptable. Even when the
pledge security is in a foreign country, pledge regis-
tration can be made in Bulgaria. Although it is not
possible to forcibly move the pledge security into
Bulgaria, nonperformance of obligation can be
charged when the pledge setting contract is violated.
Also, if the pledge security is not available, pledge
can be executed to money under Article 35.2, so
pledge registration of a pledge security present in the
country will probably function as effective means of
credit collection.
When the person who makes the authenticated
signature before the registration officer, it can replace
the authenticated signature (26 I, 27). About (2), it
seems the upper limit of the collateral credit may be
left unstated. As the pledge security with indication
of the amount as referred to in (3), the case of taking
a specific account receivable as pledge security can
be considered. The conditions referred to in (5) are
conditions set between the parties who need to cope
with the third party, and a special agreement prohibit-
ing transfer of the pledge security and the like may
be mentioned.
As items that need not authentication but are to
be registered upon consent of the other party, the fol-
lowing can be mentioned: (6) transfer of collateral
credit (including trade and lease); (7) subrogation of
collateral credit; (8) modification of debtor; (9) ac-
quisition of the right to the pledge security; and (10)
extension, extinction of collateral period (26 II, 27).
When pledge execution was made without reg-
istering (9), it is ineffective unless the third party, who
obtained the right, applies to the judge for a month
allowance of pledge execution and register the pledge
right in the meantime (36 II).
Article 8.2.2 of the Law on Registered Pledge
46 Chattel Collateral Laws of Bulgaria, Rumania and Hungary and Japanese Enterprises’ Business
allows disposal of the pledge security for the pledgor.
This provides the processing of the case the third party
who hereby acquired the right to the pledge security
does not give consent to pledge registration. If the
third party wants to obtain the pledge security, the
third party may let the pledge leave the pledge right
by paying an equivalent amount to the pledgee. The
negotiation period for this purpose is one month al-
lowance period. Article 5.4 of the EBRD Model Law
on Secured Transactions states that a money credit
with a special agreement prohibiting collateral set-
ting can be taken as collateral. Japanese Civil Code,
Article 466.2, also recognizes pledging a credit with
a special agreement prohibiting transfer, however,
only the good-faith third party with regard to the spe-
cial agreement prohibiting transfer can acquire the
pledge right. Since presence of the special agreement
prohibiting transfer can be known by seeing the credit
certificate, one who want to the pledgee cannot claim
good faith, and so normally the pledge right is not set
on the credit having a special agreement prohibiting
transfer. However, when the debtor takes from the
third debtor a written statement that the third debtor
agrees to setting of the pledge right to the credit, the
third debtor cannot maintain the special agreement
prohibiting transfer. In Bulgaria, free transfer of right
of pledge securities far wider than in Japan, because
while they do not take it so absolutely as in the Model
Law on Secured Transaction, they secure prompt so-
lution through monitoring by the court.
Items that can independently be registered in-
clude the following: (11) seizure of pledge security;
(12) seizure of collateral credit; (13) start of pledge
execution and forfeiture of execution; (14) depositor,
if any; (15) in case of enterprise collateral right, the
enterprise administrator and conditions to the enter-
prise administrator; and (16) petition for bankruptcy
and adjudication of bankruptcy (26 III).
(3) Rejection of Registration and Term of Validity
of Registration
When registration is applied for, it is not rejected ex-
cept when the registration fee is not paid, and is done
immediately. If any item is missing in the registra-
tion, registration is accepted by correction (28). When
the application for registration is rejected, the claim
can be made to the Minister of Justice according to
administrative procedure rules. If rejected by the
Minister of Justice, too, the claim can be made under
the administrative procedure law. When the applica-
tion for registration is rejected about items of regis-
tration requiring the consent of the other party about
transfer of right ((6) - (10)), and when rejection of
the application for registration is reserved, registra-
tion is done by the registration officer. When the ap-
plication for registration is rejected about other items
of registration, and when the rejection of application
for registration by the specified administrative/judi-
cial organization is fixed, registration is annulled by
the registration officer (29). The meaning of this pro-
vision stating different reactions by the registration
officer by items of the rejected registration can be
assumed as: for registration items other than (6) to
(10), even when registration is rejected, in a priority
dispute with the third party, it is possible to claim
priority by supposing that the registration was made.
Registration is valid for five years and can be
extended (30). When registration of the pledge right
is made other than at the Central Pledge Registry,
procedures related to access to registration is the same
as the procedures under the law (31). The pledge
registration made other than at the Central Pledge
Registry refers to the pledge registration made at the
Central Depository, with regard to securities without
security issue, and that made to the Commercial Reg-
ister with regard to stocks and the enterprise collat-
eral right.
5. EXECUTION OF REGISTERED PLEDGE
RIGHT
(1) Notice of Execution and Sell-out of Registered
Pledge Right
When a nonperformance of obligation occurred the
pledger starts the procedure of pledge execution (32
I). The case the pledger occupies securities/payment
certificates, too, the procedure of pledge execution
or pledge forfeit follows the law (32 II). The pledgee
notices the pledge setter of pledge execution in writ-
ing and registers the pledge execution (32 III). The
pledgee is entitled to move to its own custody and
sell the pledge security (32 IV). As no pledge regis-

tration is provided about the pledge security by occu-
pancy as stated in Article 32.2, there is no notice of
execution to the registration officer, after all. The
notice to the pledgor states the scope of the pledge
security and the pledge right collected from the pledge
security. In the case of enterprise collateral right, the
manner of selling the enterprise is mentioned (33).
The pledgee is entitled to occupies the pledge
security, notices it to the user of credit sales, keeps
the pledge security, collect the pledge right from the
pledge security, maximize the sell-out price and mini-
mize the sell-out expenses (34). When the pledgeor
does not cooperate in the occupancy removal of the
pledge security, the pledgee applies to the court judge
for delivery under the Civil Procedure Law. If the
pledge security is lost, the pledgee obtains the price.
When there is more than one pledgee and creditors
who think that the share is too small because the
amount of sell-out is too low can bring the case to the
court (35). Article 23.7 of the EBRD Model Law on
Secured Transactions provides the system of execu-
tion officer considering that a delay in taking the court
procedure and provision of requirements become the
question when the pledgor does not cooperate in oc-
cupancy removal, however, no particular system of
execution officer is placed in Bulgaria. They take
that application to the court judge may replaces it.
Rather than that the reaction of court judge is prompt,
probably this is based on a judgment that in the ex-
ecution of power as to forcibly deprive others of oc-
cupancy, no difference is needed between merchants
and non-merchants. Since trade after removal of oc-
cupancy is not the forcible execution of power, han-
dling may as well differ. Perhaps balance with a fact
that in case of the pledge right occupied by a mer-
chant who does not make pledge registration, one must
go to the court for pledge execution (no problem about
occupancy removal but sell-out is urged) is also taken
into account.
(2) Dispute about Sell-out Price
The sell-out price may be maximized within a range
it minimizes sell-out expenses, so there is no need to
sell it to a party that actually proposed the highest
price. This is because a case in which the highest
price is proposed but is accompanied with conditions
JBIC Review No.4 47
can well be considered in private sell-outs, and some-
times it require time and cost to meet the conditions.
The effect is the same as the EBRD Model Law on
Secured Transactions states in Article 24.3.1 as “make
efforts to sell it out at a fair price.”
As typical examples of disputes among multiple
creditors, a dispute about the value in collecting
money equivalent to the pledge security which is not
available, and a dispute about the asset value between
the enterprise collateral creditor and pledgers of indi-
vidual assets, may be mentioned. The enterprise col-
lateral creditor can ensure collection from individual
assets of the enterprise or sell out the enterprise as
continuing enterprise. The value of the continuing
enterprise having debts can sometimes below the as-
set value of individual assets. Considering that re-
peatedly selling individual assets will bring on higher
share, they claim to the court to suspend the blanket
transfer as continuing enterprise.
(3) Liquidation by Sell-out and Share
The pledgee is entitled to sell out the pledge security
after two weeks have passed from the notice of pledge
execution (37 I). If the sell-out is not finished within
six months thereafter, the right of sell-out moves to
another pledge registerer (37 II). The amount of sell-
out is obtained in money and deposited to the accoun-
tant appointed by the pledgee with the name of the
accountant. The allotment procedure of the sell-out
amount by the person receiving the deposit starts with
the preparation of the allotment list based on the
pledge registration and sending it to pledgees. If no
objection is expressed to the list within two weeks of
dispatch, the final allotment list is prepared within
two weeks and noticed to the pledgor, pledgees and
others involved. One who has any objection brings it
to the court within seven days. If no court is held,
allotment is made (39).
If the allotment leave any excess, it is returned
to the pledgor within seven days, however, when
the pledgor has any debt from the state or there is
another execution right holder, the excess is moved
to the pledgor account controlled by the court judge
(41). Once the pledge execution procedure has
started, it cannot not be suspended by the start of
bankruptcy of the pledgor (43 I). Pledgees having
48 Chattel Collateral Laws of Bulgaria, Rumania and Hungary and Japanese Enterprises’ Business
pledge registration receive repayment from pledge
securities prior to other bankruptcy creditors (43 II).
If no pledge securities are left by bankruptcy of the
pledgor, or if there is more than one pledgee, pledge
execution is done in the process of bankruptcy pro-
cedure (43 III).
Normally allotment takes five weeks or so, and
after the preparation of the final list, allotment is done
after the lapse of seven days. In order to make allot-
ment as early as possible, Article 28.1 of the Model
Law on Secured Transactions states that allotment be
made when 30 days have passed after the preparation
of the final allotment list. Interest parties are required
to promptly take the reaction in Bulgaria. Especially
the period of raising an objection to the court is ex-
tremely short in Bulgaria. Accordingly, creditors, in-
cluding financiers, lessors, ones who transact business
by reserving the ownership, and unpaid sellers, should
note that avoiding unsecured transactions and always
providing the pledge right with counterforce by pledge
registration is a precondition of doing business.
In the private execution of collateral right, the
obligation of liquidation is imposed on the secured
creditor, and this is natural for the pledge right of
which the ownership remains untransferred. On the
other hand, with regard to the transferable collateral
of which the ownership is moved, why part of the
ownership must be settled and returned should be
covered separately by a provision. Bulgaria does not
recognize the transferable collateral, because they do
not want to recognize taking all the collateral secu-
rity. EBRD Model Law on Secured Transactions
states in Article 24.1 that sell-out can be done only
after passing 60 days from the notice of execution,
while it can be done in two weeks in Bulgaria. As a
reason, it can be considered that, comparing with the
EBRD configuration stating that the ownership is
obtained by occupancy transfer by collateral execu-
tion and thereafter sell-out is done for the transfer of
ownership, the Bulgarian configuration as to do col-
lateral execution to cancel the pledge right does not
need careful procedures and so the period can be far
shorter. Besides, it seems they also take into account
that, if two weeks, taking preservative measures for
occupancy transfer only after the notice of collateral
execution may suffice, without installing the system
of execution officer like in the EBRD. Setting a pe-
riod to sell-out is also a consideration to facilitate sell-
out, which the Model Law on Secured Transactions
does not have. It is a device for private sell-out to
prevent the secured creditor from manipulating so that
no buyers of sell-out appear and from doing self-buy-
ing at a low price.
In Germany, when the value of collateral secu-
rity and the amount of collateral credit lose balance
in transferable collateral, it is taken as offense against
public order and a long period of time is required till
the establishment of a judgment denying taking all.
EBRD Model Law on Secured Transactions takes it
that since the obligation of liquidation is imposed on,
transfer of the ownership or not is not a significant
problem. For Bulgaria trying to provide a flexibility
to allow collateral setting without writing the amount
of collateral credit, the balance theory of Germany
may extend disputes. Bulgaria composed the chattel
collateral as pledge right, and this can be taken as a
standpoint of being apart from both the EBRD and
Gemerny. Or, this may be because legislators thought
they could not cope with the simple theory of market
economists stating that transfer to the market economy
means introduction of the concept of absolute own-
ership.
(4) Possibility of Extension to Occupied Pledge
Execution of movable properties alone by occupancy
and not by pledge registration is without the scope of
the law. However, obviously it does not recognize
the private sell-out. Articles 160 and 165 of the Law
on Obligations and Contracts have provisions about
movable properties and credit pledge to the effect that
the pledge be executed by obtaining the writ title of
obligation of execution from the court. And, the way
to obtain the writ title of obligation should follow the
example of title of obligation in the execution of
mortgage right. It can be assumed that the execution
of pledge will take time and money.
In the Japanese Civil Execution Law, conversion
of movable properties is done either by auction/ten-
der by the execution officer of the court or by volun-
tary sell-out when recognized by the court judge.
Pledge execution of nominative claim under the Civil
Execution Law does not need to obtain the title of

obligation. Also in Japan, under the Civil Code,
simple repayment appropriation is recognized about
chattel pledge and direct collection is recognized
about the credit pledge of nominative claim (respec-
tively Articles of 354 and 356 of the Japanese Civil
Code). Further, in Japan where the transferable col-
lateral is recognized, conversion by voluntary sell-
out is also taken, and, practically voluntary sell-out
is more popular.
In Bulgaria where only the pledge right is recog-
nize, probably first the title of obligation is obtained,
and then conversion, like that under the Japanese Civil
Execution Law, is done under the supervision of the
court judge specializing in execution. It seems the
question is the extent the Bulgarian court judge rec-
ognizes the voluntary sell-out similar to that under
the Japanese Civil Execution Law. Bulgarian Law
on Obligations and Contracts does not recognize
simple repayment and direct collection. As discussed
in (6) later, in the pledge execution of securities, pay-
ment certificates and stocks, improvements are aimed
at by adopting the system of voluntary sell-out, while
about ordinary chattel pledge, the method to obtain-
ing the title of obligation is not changed.
It is assumed that apart from occupancy as
pledgee, they will come to think that the pledgee may
as well make pledge registration so as to freely con-
duct private sell-out. Because, there will surely be
chattel pledgees who think it will lose balance if, when
the pledge security is not occupied, private sell-out is
recognized by pledge registration but when the pledge
security is occupied, private sell-out cannot be done
freely without pledge registration.
(5) Bankruptcy of Pledgor
The provision that if the pledgor went bankruptcy and
the pledge security is missing or in short, the pro-
cessing of pledge execution is done in the process of
bankruptcy procedure (43 II) can be considered as an
exceptional case of the procedure of voluntary sell-
out. However, for pledgees, it can be said that the
receiver in bankruptcy, who seeks the pledge secu-
rity and fix the priority order of the pledgees, cooper-
ates in doing tasks to be done by the pledgees. When
the pledge security is found, it is taken by pledgees
and produces no interest for the bankrupt estate but
JBIC Review No.4 49
the receiver in bankruptcy takes initiative in the ex-
ecution of collateral pledge. This is because, without
the pledge security, under Article 10.3 of the law the
pledgees are entitled to preferentially get repayment
of an amount equivalent to the value of the pledge
security from ordinary assets. Further, for portions
that cannot be collected by execution, pledgees can
join creditors in bankruptcy as ordinary creditors.
Leaving the dispute among registered pledgees, as is,
may sometimes result in improper processing of as-
sets of the bankrupt who is also the pledgor.
(6) Pledge Execution of Securities, Payment
Certificate and Stocks
Pledge execution of securities, payment certificates
and stocks is subject to this provision regardless of
occupancy or registration or not (44). Since conver-
sion of these pledge securities is far easier by private
execution, including voluntary sell-out in the market,
than by auction and tender, the provision does not
require the permission of voluntary sell-out by the
court each time. Pledge execution of securities and
payment certificates (promissory note, etc.) can be
done by transfer, such as secured transfer, or by sell-
out in the market (44). Pledge execution of stocks is
made be the notice to the effect that the stockholder’s
right of the pledgor has extinguished, and the notice
is registration of the pledge execution (45).
(7) Execution of Enterprise Collateral Right
The enterprise collateral creditor may choose collec-
tion by selling the enterprise itself or collection by
selling individual assets of the enterprise (46 I). When
the pledgee has chosen execution of the enterprise
collateral right by selling the enterprise, the pledgee,
in sending the notice of pledge execution, must also
add to the notice that the pledgee obtained the con-
sent of the enterprise administrator (46 II). After the
commercial registration of the enterprise administra-
tor has been done, the enterprise must not execute
any right (46 III). The enterprise administrator cov-
ers all acts about management of the enterprise, but
must not incur any new debt or dispose of asset por-
tions or give the same as collateral (48 I). Since the
task of enterprise administrator is to sell the enter-
prise as a whole unit, partial disposal and incurring a
50 Chattel Collateral Laws of Bulgaria, Rumania and Hungary and Japanese Enterprises’ Business
new debt are not recognized. If the enterprise is not
sold, the enterprise collateral creditor can discharge
the incumbent enterprise administrator and appoint
another enterprise administrator. However, if appoint-
ment is not done within two weeks, the enterprise
administrator can regain the management right of the
enterprise (51). Because, even if the enterprise ad-
ministrator failed in selling the enterprise, the enter-
prise continues and the business must surely be con-
tinued.
The enterprise administrator make a guess be-
forehand, but probably commercial registration will
be made after a nonperformance of obligation has
occurred. Or, otherwise it is not possible to leave
management to the management of the enterprise
unless there is any particular agreement about nor-
mal enterprise management between the enterprise
creditor and the management of the enterprise. The
Model Law on Secured Transactions provides an ac-
countant or a lawyer as qualification requirement in
Article 25.6.1 probably because of consideration
about fairness in sell-out and professional responsi-
bility, but no qualification requirement is provided in
Bulgaria. When actually selling an enterprise as con-
tinuing business, difficulties can be expected, includ-
ing unavailability of a well-qualified person. To cover
this, there is a provision stating that when enterprise
sell-out was unsuccessful, another enterprise admin-
istrator is appointed or the management right is re-
turned to the management of the enterprise. Perhaps
the legislature knows in the process of privatization
that enterprise sell-out is difficult. There may be opin-
ions referring to cases in which the enterprise is di-
vided and transferred or transfer of business and sell-
out of individual assets are combined, where legally
no sell-out as continuing business takes place and so
no need of choosing an enterprise administrator, how-
ever, since enterprise division is possible only when
selling of individual enterprise assets is considered
as final means, actually the enterprise administrator
will be required as one who will take the initiative.
CHAPTER III CHATTEL
COLLATERAL LAWS OF RUMANIA
AND HUNGARY AND REACTION OF
JAPANESE ENTERPRISES
1. CHATTEL COLLATERAL LAW OF RUMANIA
(1) Method of Collateral and Object of Collateral
Features of Rumanian chattel collateral law are
summed up in the following. Compared with the
EBRD Model Law on Secured Transactions law, with
regard to the chattel collateral, the law allows more
free application of collaterals. Unlike Bulgaria, no
consideration is given as to raise conative impulse in
practical application of the law by maintaining com-
patibility with the existing legal system.
The law does not function substantially since the
scheme of digital collateral registration has not been
established yet as of November, 2000. However,
when digital collateral registration comes into func-
tion, the coverage is so widespread as no business is
possible without this chattel collateral registration,
since business in Rumania requires the chattel collat-
eral registration for both collateral transactions and
other trades as well. The law replaces chapters of the
Commercial Code relating to pledge right, texts of
the Civil Procedure Law relating to the public notice
of collateral execution in pawnbroker operation, and
all the orders and regulations opposing the law (Ru-
manian Chattel Collateral Law (Section II of Law on
Steps to Expedite Economic Reform), Article 104
(henceforth abbreviated as 104, etc.). The counter
requirement of credit transfer was conventionally to
notice of the debtor of the credit transfer or get the
consent, but hereafter these will subordinate to the
collateral registration of credit transfer (99). Also,
when the digital collateral registration system start
functioning, creditors need to re-register the collat-
eral right within 120 days (102). Therefore, conative
impulse of the law is not high in application, but it
seems that when the digital collateral registration sys-
tem is established, it will inevitably raise the conative
impulse.
As Rumanian chattel collateral system is applied
to all private and commercial contracts as well as

merchants (1), the scope of application is wider than
the chattel collateral laws of Bulgaria and the EBRD.
Transfer of accounts receivable that are not the ob-
ject of collateral, conditioned transactions, lease in-
cluding ones extending more than a year, consign-
ment sales contracts, and the priority, registration and
execution of warehouse securities and bearer stocks,
are subject to the law (2). Movable properties and
credits that can be transferred can be taken as collat-
eral securities, and are specifically stated in Article
6. Collateral securities can be either currently present
or generated in the future, whether tangible or intan-
gible, indicated in domestic or foreign currency, or
specific or nonspecific. Further, when the content
and nature are fixed on the contract day, all the mov-
able properties of the collateral setter are also accept-
able (10). While the collateral of movable properties
and rights is widely recognized, there is no express
statement as to recognize the enterprise collateral
right. Probably this is based on an understanding that
since the collateral of movable properties held by
enterprises, especially of the land, is done at the Land
Registry handling all the rights related to land, it can-
not be handled like registration of the collateral of
movable properties at the Registry. There is a provi-
sion stating as, when the creditor makes the collat-
eral registration of a movable property for the rebuilt
portion thereof, it precedes the collateral registration
of the mortgage right of land (35), and this recog-
nizes the collateral registration of certain movable
properties that precedes the mortgage right of land.
If the debtor neglected the performance of obligation,
the secured creditor is entitled to occupy, adminis-
trate and sell the collateral security (11).
Collateral setting of collateral securities in for-
eign countries are subject to laws of the country, but
when collateral registration is made within 60 days
of delivery of the collateral security into Rumania or
within 15 days of knowing the effect, the priority right,
taking the time of collateral setting in foreign coun-
try as collateral registration in Rumania, is given (91).
When a finance company leases a movable property
34 When the author made interviews in Moscow in 1998, many of the Russian venture capitals invested by EBRD invested in
Cyprus corporations as direct investment to Russia. Namely, they invested in Cyprus corporations having branches in Russia or doing
business there. Many businesses via Cyprus were seen in Kazakhstan, too, where the author stayed from 1996 to 1997.
JBIC Review No.4 51
in a foreign country, and when the collateral right
cannot be set in the foreign country, the company can
secure the priority by registering the collateral right
within 60 days of delivery into Rumania (92). Even
a tangible asset moved to a foreign country or an in-
tangible asset used in a foreign country, if it belongs
to the debtor, registration of the collateral right can
be made at the address place of the debtor (93). Even
when the debtor moved the address to a foreign coun-
try, the same priority can be obtained in Rumania by
registering the collateral right in the place (94). When
there is no chattel collateral system in the foreign
country to which the debtor moved the address or the
movable property is not occupied by the creditor, pri-
ority in the collateral subordinates to the collateral
setting to the receiving account in Rumania, or to the
collateral registration in case the movable property is
in Rumania (95).
The Rumanian Chattel Collateral Law provides
chattel collateral in foreign countries so much in de-
tail as above, and as a background, the presence of
the Double Taxation Prevention Treaty with Cyprus,
a tax haven can be considered.
Enterprises in Rumania and Russia/CIS move
their legal personality to Cyprus aiming at taxation
measures.34 Bearing low tax rates in Cyprus, they
report to taxation authorities in Rumania and Russia/
CIS as tax paid. In 1998, Bulgaria discarded the
Double Taxation Prevention Treaty with Cyprus and
does not allow such tax cut measures by corporations
and persons doing business in the country.
(2) Establishment of Chattel Collateral and
Registration
The chattel collateral contract is not established
unless it is made in writing with the signature of the
debtor, but it can be replaced by endorsed transfer to
securities (13, 14). The amount of collateral credit
does not need to be stated (15), but the collateral set-
ter can obtain the confirmation of the collateral setter
by declaring the amount of collateral credit (26).
By registering to the digital collateral register,
52 Chattel Collateral Laws of Bulgaria, Rumania and Hungary and Japanese Enterprises’ Business
the counterforce can be obtained (29). The occupied
collateral right of which the collateral right is estab-
lished without digital collateral registration is 300
Euro or less in amount of collateral credit and includes
money/securities/signed certificates (deposit certifi-
cate, B/L, check and promissory note, including en-
dorsement as well as occupancy), listed securities (re-
quiring registered pledge), and ships/aircraft
(collateral registered to ownership register) (30). For
loans for purchase supplied to the unpaid seller col-
lateral right holder and the buyer, when the notice of
collateral setting was registered before the debtor
started occupancy and the existing registered collat-
eral creditor received the notice, the collateral right
precedes the existing registered collateral creditor
(33). When the collateral security is changed to an-
other object, which is a movable property other than
money, deposit and checks, the collateral right ex-
tends to the object by changing the collateral notice
(34). The fruit of the collateral security belongs to
the collateral creditor, and is appropriated for the pay-
ment of maintenance costs and the amount of debt
(39). Collateral registration is effective for five years
and can be renewed repeatedly, as desired (44).
Digital collateral registration is controlled by
collateral setters and collateral securities, held by as-
sociations of private citizens and corporations selected
by tender under the supervision of the supervisory
government agency, mutual connected via a computer
network, and made accessible even outside the busi-
ness hours (45. 53). The register is a database. Col-
lateral registration fees are set by the principle of com-
petition between registration organizations, and the
supervisory agency must not guide them (51, 52). The
collateral notice is inputted either manually or digi-
tally, and the noticer obtains a copy of the collateral
notice within 24 hours (57, 58).
(3) Execution of Chattel Collateral
Execution of chattel collateral is done either by the
Civil Execution Law or by the voluntary sell-out of
the law (62). When the effect that the execution of
chattel collateral is made by starting occupancy/con-
version to cope with the nonperformance of obliga-
tion is written in the collateral setting contract with
letters 0.5cm square and larger, collateral execution
may be done without the prior notice and fees, but
the start of occupancy must not accompanied by civil
servants or the police and must not disturb public or-
der (63). Even without occupancy, the creditor can
sell the collateral security (65). If it is not possible to
start occupancy in a peaceful manner, occupancy can
be restored by asking the execution officer (67). As
the method of selling the collateral security, volun-
tary sell-out to the third party, auction via newspaper
announcement, and sell-out in the market, however,
the sell-out price must be a commercial price equiva-
lent to a proper highest price (69). Sell-out must be
noticed to the debtor and other creditors by seven days
before the planned date of sell-out so that they can
bring an action against the sell-out (71, 75).
The share procedure of the sell-out amount can
be done by the collateral creditor, and unlike the
EBRD Model Law on Secured Transactions, there is
no system of money keeper aimed to secure the fair-
ness of distribution. An excess amount after paying
the debt from the sell-out amount of the collateral
security is returned to the debtor within three days of
sell-out (78). Even when bankruptcy or corporate
reorganization procedure is started before the collat-
eral execution procedure is finished, the procedure
can be continued (86: In Japan, collateral execution,
if not finished yet, is suspended.). The creditor who
made sell-out violating the law pays damages corre-
sponding to 30% of the collateral credit or the differ-
ence between sell-out price and market price, which-
ever is the larger (88).
2. HUNGARIAN CHATTEL COLLATERAL
LAW
(1) Features of Collateral System Reform in
Hungary
The content of legislature of the Chattel Collateral
Law in Hungary is summarized. In Hungary, legisla-
tion of the Chattel Collateral Law is done by revising
chapters of pledge right and mortgage right of the
Civil Code (Act 26 of 1996 on the amendment of
Certain Provisions of the Civil Code). So, more con-
sideration is given to compatibility between chattel
pledge and credit pledge and between pledge right
and mortgage right. The distance from the EBRD

Model Law on Secured Transactions is farther in or-
der of Rumania, Bulgaria and Hungary. Polish Chat-
tel Collateral Law may be positioned between Ru-
mania and Bulgaria.
Points in the Amended Civil Code are: (1) in
pledge on credit right, collateral registration and vol-
untary sell-out are recognized; (2) the floating pledge
and floating mortgage right are recognized; (3) one
year of extension is recognized for the extinction of
collateral right; and (4) collateral execution on con-
dition of evacuation is recognized for immovable
properties for dwelling.
In the Model Law on Secured Transactions, (1)
and (2) are provided but (3) and (4) are not. (2) states
as “When taking the credit right generated from a last-
ing contract relations as collateral, a collateral secu-
rity can be obtained by setting a limiting amount (Ar-
ticle 260.4 of the New Civil Code under Article 1 of
Hungarian Act 26 of 1996 on the amendment of cer-
tain provisions of the Civil Code (henceforth abbre-
viated as H260, etc.), and further “The pledge right
(“lien” in English transaction in Official Gazette) can
be set even when there is no credit right or the credit
right is extinguished, and in this case the pledgee
(“lien” in English transaction in Official Gazette)
receives payment from the pledge security according
to the amount stated in the pledge setting contract
(H269 I).” By setting a limiting amount, the floating
pledgee receives preferential payment with an actual
credit amount realized at time of cristalization. In
this case, the pledge right comes to extinction by the
notice of finished payment made by the pledgor (lie-
nee) or the pledgee (lienor), and the notice is made
within six months from the payment (H269 II).
(4) expressed that an idea that immovable prop-
erties for dwelling will never be taken, a remain of
the socialistic times, is abolished. They set forth a
capitalistic concept as the people’s dwelling right is
not the one the state guarantees. In this sense, too, it
can be said that among other Central and East Euro-
pean countries, Hungary is closest to participation in
the EU. (3) seems to be a concept developed from
the concept of floating pledge and floating mortgage.
Even when the mortgage right is extinguished, the
mortgagor must keep free the disappeared mortgage
order for one year after the extinction registration and
JBIC Review No.4 53
can give the order to a new creditor (H268 II). Since
the order of subordinate mortgagee does not rise as
the natural result of extinction of the priority mort-
gage right, the system is favorable to collateral credi-
tors in a special relationship with the debtor. Regis-
tration to secure the priority order of mortgage right
is made to the land register (Article 7.1 of the Re-
vised Real Estate Registration Law under Article 5
of the Act 26 of 1996 on the amendment of certain
provisions of the Civil Code). This seems influenced
by the order reserve system of real estate mortgage
right in Germany.
The pledge right comes to extinction when the
pledge security is returned to the pledgor, but when
occupancy is not voluntarily lost, the law provides
that the pledge right remans in effect for one year,
allowing one year as period for taking another pledge
security (H268 III).
(2) Object of Pledge Right
Object of the pledge right includes movable right and
credit, so the pledge right is partly not established,
and in real estate, the pledge right or mortgage right
are established for the registered portion or the entire
real estate of the secured creditor (H252). Unlike
Bulgaria, this recognizes real estate pledge, too.
In the case of the credit pledge, the pledgee can
execute the pledge right by registering the notice of
pledge setting agreed by the pledgor to the Notary
Public Association and obtaining the written docu-
ment of voluntary sell-out from the pledgor. Here
the concept of the EBRD Model Law on Secured
Transactions is introduced, as is. However, unlike
the EBRD Model Law on Secured Transactions, the
text of the law is made by adding the minimum revi-
sion on the conventional Hungarian Civil Code and
the related laws. Because of this, unlike the EBRD
and Bulgaria, the pledgor that can register credit
pledges is not limited to traders. This is the same in
Rumania, but since Rumania newly introduces a to-
tally different law, there the conative impulse to se-
cure the binding force of law does not easily grow
among targets of the law.
When the pledge security is the credit or right,
the pledgee can prepare the legal statement (or the
notice of pledge setting) relating to the collateral by
54 Chattel Collateral Laws of Bulgaria, Rumania and Hungary and Japanese Enterprises’ Business
obtaining the consent of the pledgor (H258 I). The
pledgee can execute the pledge right by showing the
legal statement to the debtor of the credit or right,
namely the pledge security (261 II). The legal state-
ment can be registered to the Notary Public Associa-
tion under Article 47 of the New Civil Code Imple-
mentation Order, under Article 2 of the Hungarian
Act 26 of 1996 on the amendment of certain provi-
sions of the Civil Code. The secured creditor can ask
voluntary sell-out to an auctioneer or a collateral loan
professional by a prior written agreement, without the
collateral execution procedure by the court (H264 II,
III).
To let the pledge right to the fruit of pledge right,
an agreement must be reached between the parties
(H253 II). When the agreement is available, the
pledgee can use the collateral security and obtain the
fruit, and, in addition to appropriating the fruit for
storing the pledge security, can appropriate it to the
credit (H257 II). From the provision that the pledge
right extends to an object that will come in the future,
too (H253 II), it is clear the a floating pledge is avail-
able. Corporations (legal entities) and an incorpo-
rated economic association can set the enterprise col-
lateral right to an entire of enterprise assets or the
specified assets thereof (H254 I). In the execution of
the pledge right, if changes in pledge security is not
pledge registered, it cannot cope with the third party
who obtained the pledge security with good faith and
onerously (bona fide and for consideration, H254 II).
(3) Establishment of Collateral Right and
Registration
Pledge setting must be made first by the contract, and
when the credit or the conditioned pledge right is taken
as pledge security in the future, or when the pledgor
obtains the disposal right about the pledge security
after exchanging the contract, it must be made by a
written contract (H259). Mortgage setting to the real
estate register is made by a written contract and mort-
gage right setting should be registered to the real es-
tate register (H260). In the practical registration,
however, it is provided that the mortgage setting con-
tract must be made by the notarized deed (Article 47.2
of the Revised Civil Code Implementation Law un-
der Article 2 of the Act 26 of 1996 on the amendment
of certain provisions of the Civil Code). When pledge
setting to movable properties on the real estate to
which the mortgage right is set is desired, the pledge
contract must be authenticated and collateral regis-
tered to the Notary Public Association (H260 II). It
should be understood as all the contracts relating to
real estate collateral are to be made via the notary
deed and collateral registered. Collateral registration
requires the amount of collateral credit and the fruit/
expenses covered by collateral to be registered, but
the reduction of amount/extinction of the collateral
credit is effective irrespective of registration (H260
III).
Pledge setting required, in addition to the con-
tract, occupancy for pledge securities of which occu-
pancy can be transferred and collateral registration
for pledge securities comprising rights and credits
(H261). Registration rules and fees at the Notary
Public Association that handles collateral registration
of the pledge right are subject to the government or-
der (Act 26 of 1996 on the amendment of certain pro-
visions of the Civil Code, Article 9). Since the law is
applicable to the collateral right that remains effec-
tive passing May 1 1997 (Article 8 of the Act 26 of
1996 on the amendment of certain provisions of the
Civil Code), contracts setting pledge securities ear-
lier need to re-register the pledge right. Incidentally,
the law does not provide anything about the validity
term of pledge registration.
According to the interview at a local law of-
fice, the social position of notaries, who are not gov-
ernment agencies, is high in Hungary from before,
this pledge registration procedure goes quite
smoothly and is used very popularly. Practical
pledge registration procedure is done as: the Notary
Public Association forms computer networks and the
results are made into a database. Accordingly, by
visiting a notary public office, everybody can con-
firm the presence of the pledge right of relevant en-
terprises and persons at low fees. Chattel collateral
is composed along the conventional legal scheme
and registration procedure of chattel collateral is left
to notaries, who have a high social status but are
non-government agencies. While this has realized
a business-like collateral registration system, it
seems this allows the conative impulse to secure le-

gal execution force to work more easily, a big dif-
ference from Rumanian Chattel Collateral Law
where assumably conative impulse cannot work so
easily.
(4) Execution of Pledge Right
Pledge execution basically requires the court deci-
sion about execution (H262). The pledge forfeiture
contract is prohibited (H263 I). Payment from pledge
execution is subject to the order of pledge collateral
(H263 II). In pledge execution, the parties can reach
an agreement about the lowest price at auction and
the terms of pledge execution, and if conditions are
not met, pledge execution by auction cannot be done
(H264 I). When the pledge security has a market price
or when the collateral loan professional (such as a
pawnbroker) is the pledgee, an agreement can be
reached by a written agreement about voluntary sell-
out without the collateral execution procedure by the
court, and in other cases, too, an agreement can be
reached by a written agreement about voluntary sell-
out by an auctioneer or a collateral loan professional
by a written agreement, without the collateral execu-
tion procedure by the court (H264 II, III).
Before the sell-out, the pledge setter receives the
notice (H265 I). This gives the pledgor a chance of
redemption. The sell-out amount of pledge security
belongs to the pledgee, but when it exceeds the amount
of collateral credit, the excess must be returned to the
pledgor, and a prior agreement of non-liquidation is
ineffective (H 265 II). Pledgees who can get paid
only partly by pledge execution can collateral regis-
ter the remaining collateral credits (H266 II). The
pledge right or the mortgage right of which the ex-
clusive preference right or collateral right can be ex-
ecuted at time of bankruptcy/liquidation must be the
collateral right set six months prior to the start of bank-
ruptcy/liquidation (Article 57.1.b of the Revised 1991
Bankruptcy/Liquidation Procedure Law under Article
6 of the Act 26 of 1996 on the amendment of certain
provisions of the Civil Code).
35 Of course the legal information and translation by Japanese/local staff who can understand local languages are useful, but their
interpretation/understanding about local laws is sometimes insufficient.
JBIC Review No.4 55
3. NOTES FOR JAPANESE/JAPAN-BASED
ENTERPRISES
Generally, points to be noted by Japanese enterprises/
Japan-based enterprises are the following: (1) Start
business only after confirming whether chattel col-
lateral registration is possible or not. Even for ordi-
nary sales and lease contracts, such as the unpaid seller
collateral right, ownership reserve and installment
sales, sometimes credit collection becomes insuffi-
cient without chattel collateral registration; (2) When
financing a local enterprise, take the chattel collat-
eral locally; (3) Take the possibility of LBO, by blan-
ket collateral registration of unspecified future ac-
counts receivable in Central and East European coun-
tries, as a management strategy; (4) Recognize, not
generally but as business-legal affairs related to each
business transaction, that the national situation dif-
fers by countries in Central and East European coun-
tries; (5) Take economic problems like restoration of
the macroeconomy and development of the market
economy as management problems, such as the in-
fluence of weak Euro currency or whether or not fac-
tors allowing the power/energy to use, execute and
observe laws of market economy actually exists; and
(6) Collect local laws relating to business, especially
the text with reliable English translation, and exchange
information accumulated this way, aiming at quality
improvement of information.35
In this text, chattel collateral laws of Central and
East European countries were analyzed, centering on
that of Bulgaria, but for Rumania and Hungary, only
the summaries were given. The author believes that
making analyses like this about other specific busi-
ness laws of individual countries, compiling and
openly supplying the results to possible investors, will
increase direct investments in Central and East Eu-
rope and lead such direct investments to success.
56 Chattel Collateral Laws of Bulgaria, Rumania and Hungary and Japanese Enterprises’ Business
REFERENCES
Japanese References
Ohmi, Koji. 1998 “Collateral Right Law (new edi-
tion), Kobundo
Kobayashi, Hideo. 1972 “Enterprise Collateral Law”,
“Railway Mortgage Law, Track Mortgage Law,
Enterprise Collateral Law”, Daiichi-hoki
Sato, Setsuko. 1997 “Right and Obligation – Binding
Force of Law –”, Seibundo
Sato, Yasunobu. Aug., Sept. 2000 “Introduction of
Model Collateral Law and Commentary, NBL
Suzuki, Koji. 2000 “Bankruptcy Law and Chattel
Mortgage Law in Asian Countries”, Chuo
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aaaaaaaaaaaaa
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on Registered Pledges”.
Taylor Joynson Garrett, “Law No.99/1999 on Steps
to Expendite Economic Reform”.
“Amendment of Certain Provisions of the Civil Code
of Hungary” provided by GBM & T Law Office
 JBIC Review No.4 57

RURAL ENTERPRISES FINANCE :

A CASE STUDY OF THE BANK OF AGRICULTURE AND AGRICULTURAL
COOPERATIVES (BAAC) IN THAILAND1

Naohiro Kitano*

I. THE BACKGROUND AND including rural non-farm enterprises, by amendments

OBJECTIVES OF THE SURVEY to the Act in 1999.

The promotion of the rural non-farm economy, espe-

cially the rural enterprises2, in the rural areas of Asia
has been emphasized in recent years against the back-
drop of rising unemployment caused by changes in
the rural economic structure (conversion to non-agri-
cultural employment) and the economic crisis, etc.
As a result, microfinance and various other policy
measures have been studied and implemented.
The objective of this survey is, within the rural
enterprise promotion policy, to examine the financial
support provided to those enterprises that have moved
beyond the microfinance level. The case studied3 is
that of a prominent rural financial institution, the Thai
Bank of Agriculture and Agricultural Cooperatives
(BAAC)4 in Thailand, which has been financially
supported by JBIC since the 1970s. BAAC has been
authorized to provide loans to the non-farm sector,
CHAPTER 1. CHANGES IN THE
STRUCTURE OF THE THAI
REGIONAL ECONOMY
1.1 INDUSTRIALIZATION SPREADS TO THE
REGIONAL AREAS
The Thai economy grew more than 8% a year from
1987-1995, centered on the manufacturing industry.
Changes in the industrial structure spread from
Bangkok Metropolitan Region throughout the coun-
try. Trends in the ratio of added value in the manu-
facturing industry from 1986-1995 shows that it rose
significantly in many regional areas, while it peaked
in Bangkok Metropolitan Region, where there already
was an excessive concentration (Fig. 1).

* Senior Economist, Director, Research Institute for Development and Finance.

1 This is an executive summery of the JBIC Research Paper No.7 (Japanese only) “A Case Study of the Bank of Agriculture and
Agricultural Cooperatives(BAAC).” Researchers in charge of this survey are JBIC: Naohiro Kitano and Seiji Nishii, Consultants: Yuuji
Kurokaya, UNICO and Tomoo Mochida, OMPAC. This research was conducted with the cooperation of Takashi Matsuya, JICA expert
and Dr. Fumiharu Mieno, associate professor of Hosei University. In July 2000, the outcome of this research was feedbacked to the
senior management of the BAAC.
2 This includes the processing of agricultural products, textiles and other rural industries, transport and other service industries,
and agricultural product distribution and other commercial industries. Enterprises in rural area marketplace, are also included.
3 In addition to interviews with related institutions in the areas concerned, it also involved the interview of more than 30 rural non-
farm enterprises.
4 BAAC is one of the governmental financial institutions which was established in1966, reforming and successing BAC(Bank for
Cooperatives), based on the BAAC law. Its main purpose is to supply agricultural credit for farmers, farmer-groups and farmers’
cooperatives. BAAC holds approximately 70% of Thailand’s farmers as its customer. In advance of BAAC law amendment in 1999,
financing agriculture-related activities was commenced by law amendments in 1992. BAAC has 13 thousand employees and leads 1500
branch offices. Policy decisions are made in the board of trustees whose chief is the Minister of Finance. Besides JBIC, Asia Develop-
ment Bank(ADB) finances BAAC.

JBIC Review No. 4 May 2001 pp 57~71

©2001 by Japan Bank for International Cooperation. All rights reserved.
58 Rural Enterprises Finance : A Case Study of the Bank of Agriculture and Agricultural Cooperatives (BAAC) in Thailand

Fig. 1: The ratio of added value in the Thai manufacturing industry to all production 1986-1995
(1988 prices)
Manufacturing industry Number of employees
Micro Enterprises 1∼4
Small Enterprises 5∼19
Medium Enterprises 20∼199
Large Enterprises 200 or more

Commercial sector and service industry Number of employees

Micro Enterprises 1∼4
Small Enterprises 5∼19
Medium Enterprises 20∼99
Large Enterprises 100 or more

Source: Interviews with ADB (Asian Development Bank)

1.2 THE INCREASING PROVISION OF of access to regional cities resulted in an expanded

INFRASTRUCTURE
Infrastructure such as roads has been developed dur-
ing this period across the country. This greatly spurred
economic activity and boosted the quality of life. For
example, there were 22,404 kilometers of paved roads
in 1981. This had more than doubled to 46,331 kilo-
meters by 1995. Progress of roads development in those
areas such as the Northeast and North Regions was
equivalent to that of the rest of the country (Fig. 2).
During this time, there was a dramatic increase
in the number of vehicles not only in Bangkok Met-
ropolitan Region, but also in other regions. A look at
the average number of pick-up trucks per household
in the rural areas of the Northeast Region shows a
sharp increase in the areas adjoining trunk roads link-
ing regional cities during the six-year period from
1986-1992 (Fig. 3). It is assumed that by farmers
having their own means of transportation, there was
a major improvement in access to the market for har-
vested agricultural products and the products of rural
non-farm enterprises. Additionally, the improvement
commuting area and improvements in non-agricul-
tural income.
During this economic growth, the average ratio
of non-agricultural income in the farm household
economy nationwide rose from 60% in 1986/1987 to
67% in 1991/1992 (Fig. 4). The average income per
farm household climbed from 22,306 Baht in 1986/
1987 to 34,163 Baht in 1991/1992.
This is thought to be largely due to the increase in
local employment opportunities caused by the greater
presence of the manufacturing industry, primarily in
the Central Region. The increase in non-farm income
in the Northeast is due to the increase in remittances
from family members working in urban areas, like the
Bangkok Metropolitan Region or overseas.
1.3 THE IMPACT OF THE ECONOMIC
CRISIS
Meanwhile, the economic crisis since 1997 had a
sharp impact on rural areas. It reduced the employ-
ment opportunities in these areas, as the number of

Fig. 2: Length of paved roads by Region (1981-1995)

(km)
50,000
40,000
30,000 1981
1995
20,000
10,000
0
Nationwide Central Northeast North South
Source: Ministry of Transport and Communications
 JBIC Review No.4 59

employed persons in the agricultural sector fell 1.3%
year-on-year in August 1998, and 5.5% year-on-year
in August 1999. In addition, the real average income
of rural areas plummeted, though not at the same level
as in the cities (Fig. 5)5. Therefore, the creation of
employment in rural areas by promoting rural non-
farm enterprises and other non-farm activity, and the
stabilization and improvement of the quality of life
have become important policy issues.

Fig. 3: Spread of pick-up trucks in the Northeast Region of Thailand (1986-1992)

1986 NETVIS 04-Oct-97 1992 NETVIS 04-Oct-97
(c)1994-1997 NAGATA Yoshikatsu (c)1994-1997 NAGATA Yoshikatsu
Media Center,Osaka City Univ. Media Center,Osaka City Univ.
Source:Village Database B.E.2529 Source:Village Database B.E.2535

0.01 0.01

0.02 0.02
N16° N16°
0.03 0.03

0.05 0.05

0.1 0.1

0.2 0.2

0.3 0.3

N14° E102° E104° N14° E102° E104°

pick-up trucks per household pick-up trucks per household

0 50 100km 0 50 100km
Figure 10 Pick-up Trucks Figure 10 Pick-up Trucks
Source: Nagata (1996)

Fig. 4: The ratio of non-agricultural income in the Thai farm household economy
(Average per farm household) 1986/1987 ~ 1991/1992
(%)
80.0
75.0
70.0
65.0 1986/87
60.0 1991/92
55.0
50.0
Nationwide Central Northeast North South
Source: NESDB

Fig. 5: Real average income (1996-1998)

(Baht)
7,000
6,000
5,000 1996
4,000 1998

3,000

2,000
Nationwide Urban areas Rural areas
Source: World Bank (2000)

5 The real wages in the agricultural sector, with those of 1997 as 100, fell to 85 in 1998, while those in the manufacturing industry
fell only to about 95.
60 Rural Enterprises Finance : A Case Study of the Bank of Agriculture and Agricultural Cooperatives (BAAC) in Thailand

CHAPTER 2. THE STATE OF RURAL farming population (Fig. 6)6.

NON-FARM ENTERPRISES
2.1 THE DEFINITION OF RURAL NON-FARM
ENTERPRISES
There is no clear definition for rural non-farm enter-
prises in Thailand. In this report, we define the rural
non-farm enterprises surveyed as medium- and small-
sized enterprises and microenterprises operated by
residents of rural areas primarily consisting of the
For a breakdown by size, we classified the enter-
prises based on the number of employees due to the
restricted data available (Table 1)7. The breakdown
of rural non-farm enterprises by sector compiled by
the BAAC shows that some enterprises can be started
with a relatively small investment, and that a wide
range of economic activities are included in addition
to the manufacturing industry (Table 2).

Fig. 6: The positioning of the rural non-farm enterprises surveyed

Large enterprises
Note: *1. Webster et al. define survivalists as the people
engaged in various economic activities on a part-time
Medium basis, the self-employed as the people manufacturing
enterprises items for sale, purchasing items for resale, or providing
Rural Enterprises

services, and microenterprises as extremely small

Small
Surveyed

enterprises enterprises engaged in ordinary activities within a certain

range at a specified location for a specified time.
*2. The entities shown with the broken line are those
Informal sector individuals, microenterprises, and medium- to small-
Micro- sized enterprises thought to be potential recipients of
Survey- Self- BAAC financing, including microfinancing. The
valist Employed Enter-
Persons prises entities in the shaded area are positioned as rural non-
farm enterprises in this survey.
Source:Compiled based on Webster et al. (1995)

Table 1: Definition of medium- and small-sized enterprises

Manufacturing industry Number of employees
Micro Enterprises 1∼4
Small Enterprises 5∼19
Medium Enterprises 20∼199
Large Enterprises 200 or more

Commercial sector and service industry Number of employees

Micro Enterprises 1∼4
Small Enterprises 5∼19
Medium Enterprises 20∼99
Large Enterprises 100 or more

Source: Interviews with ADB (Asian Development Bank)

6 The survey subjects in this report principally are assumed to have been one step above the microfinance level. In the case of
BAAC, the maximum financing amount in the pilot microfinance project with GTZ was set at 100,000 Baht. The borrowers were the
self-employed persons or the microenterprises shown in Fig. 6. Being a farmer was not a requisite in the loan conditions. The emphasis
in this report is on those enterprises at a slightly higher level.
7 The definition of medium- and small-sized enterprises differs with each institution, such as Bank of Thailand and International
Finance Corporation of Thailand (IFCT). This paper, out of the provisional proposal of the Ministry of Industry(which divides micro-
enterprises and small enterprises based on the number of employees, registered capital, and sales), expediently adopted the definition
based on the number of employees.
 JBIC Review No.4 61

Table 2: Breakdown of rural non-farm enterprises

Industry Sectors

Industrial Drinking water, ice production, furniture, bending iron making, brick, confections, rice mills,
rice noodle machines, noodles, casting product processing, cement products, wooden buckets

Commercial Miscellaneous goods, retail, supermarkets, sales of construction materials and equipments,
electronic devices, spare parts, furniture, noodles and agricultural implements, restaurants

Service industry Parking lots, motorcycle repair shops, gas stations, beauty parlors and barber shops,
construction industry, tailors, transportation business

Note: Enterprises eligible for non-agricultural financing from BAAC.

Source: BAAC

Fig. 7: National distribution of enterprises and industries in Thailand

1,000,000
800,000 Service industry / Others
Commercial sector
600,000
Manufacturing industry
400,000

200,000

0
Nationwide Metropolitan region Municipal area Sanitary area

Source: 1996 National Survey of Business Enterprises

2.2 OVERVIEW OF RURAL NON-FARM
ENTERPRISES
There are no statistics that comprehensively cover
rural non-farm enterprises in Thailand. Therefore,
for the sake of convenience, we used the “1996 Na-
tional Survey of Business Enterprises” published by
the Thailand National Statistical Office to examine
the current state of medium- and small-sized enter-
prises as well as microenterprises such as in the manu-
facturing industry, the commercial sector, and the ser-
vice industry. This survey revealed a total of about
850,000 business enterprises nationwide. Of these,
the highest number of business enterprises were those
whose scope of operations was the sanitary area8
(about 350,000 enterprises) (Fig. 7)9. Other statistics
indicate that the number of rural enterprises is about
the same as the number of enterprises operating at
the sanitary area level. Combining the number of
these two and subtracting the number of large enter-
prises from the total leaves a rough figure for the num-
ber of rural non-farm enterprises.
A breakdown by sector shows that the ratio of
small microenterprises is extremely high in all the
sectors. This trend is particularly pronounced inside
the Metropolitan Region. For example, a look at the
distribution of enterprises by size in the manufactur-
ing industry shows an extremely high proportion of
microenterprises at the sanitary area level (Fig. 8). It
is estimated that roughly the same trend holds true
for rural areas.

8 Thailand is constituted of Bangkok Metropolitan Region and 75 Changwats(Provinces). Under the Provinces, there lies admin-
istrative units called Amphoe(Districts). Within each District, the most developed Area is called a Skapibaan(Sanitary Area), and among
Sanitary Areas,the center respective of the Province is called a Tessabaan(Municipal Area). Other areas are regarded as rural areas.
9 These statistics cover enterprises with more than one employee in the manufacturing industry, commercial sector, and the
service industry. (The survivalists and self-employed persons of Fig. 6 are not included.) They only cover enterprises down to the
municipal and sanitary area levels, however. The only statistics of the same type available for rural areas are limited to enterprises in the
manufacturing industry with at least 10 employees.
62 Rural Enterprises Finance : A Case Study of the Bank of Agriculture and Agricultural Cooperatives (BAAC) in Thailand

2.3 THE STATE OF RURAL NON-FARM
ENTERPRISES
A look at the constituent elements of the number of
employees of the 34 enterprises in this on-site survey
arranged by BAAC shows that 12 are classified as
microenterprises (Table 3). Most are thought to be
enterprises for the family livelihood10.
The companies visited responded that the finan-
cial institution that provided financing was BAAC in
most cases, as to be expected. In some cases, how-
ever, the enterprises borrowed from both BAAC and
another financial institution (Table 4).
The sites selected for visits were rural non-farm
enterprises, which are in principle supposed to receive
at least 500,000 Baht in financing. However, in fact,
about 50% of the sites received less than 500,000 Baht
in financing. The enterprises that identified the fi-
nancing amount are classified by the amount they
borrowed, as shown in the following table. Most of
the enterprises borrowed less than 1 million Baht
(Table 5). The financing was to be used as funds for
facilities or operating expenses etc., most of the en-
terprises visited received loans for facilities expenses

Fig. 8: The distribution of enterprises by size in the manufacturing industry

(%)
100 Large enterprises
80 Medium-sized enterprises
60 Small-sized enterprises
40 Micro enterprises
20
0
Metropolitan region Municipal area Sanitary area
Source: 1996 National Survey of Business Enterprises

Table 3: Distribution by size of the enterprises Table 4: The financial institution, etc.,
surveyed providing the loan
Size of enterprise Number of enterprises Number of enterprises receiving loans and
Financial institution from which responses were received
Micro enterprises 12
BAAC 27
Small-sized enterprises 14
SIFC 3
Medium-sized enterprises 8
IFCT 3
Total 34
Northeastern Agriculturale
Development Office 1
Source: On-site survey
IPC 1
Government-affiliated
financial institution 1

Bangkok Bank 3
Ayutthaya Bank 1
Private sector lenders 1
Total 41
Note: These are financial institution, etc., currently providing
financing. There are some enterprises that have borrowed
from more than one financial institution. Therefore, the
total number of enterprises above is greater than the
number of enterprises surveyed.
Source: On-site survey

10 Kiyonari (1990) classifies medium-, small-sized and micro-enterprises into four groups. They are, (1) Conventional companies,
(2) Corporate family enterprises (Operations primarily comprised of the owner and employees who are family members), (3) Enter-
prises for the family livelihood (Primarily similar to those in (2) but are not evolved to the company level in which operations and
household expenses are separate), and (4) Subsidiary and auxiliary family enterprises (Economic activities to supplement household
expenses). In this paper, the subjects are primarily those enterprises in (1), (2), and (3).
 JBIC Review No.4 63

Table 5: Distribution of financing amounts

Amount borrowed (Baht 10,000) Number of loans Note: *1. Of the companies visited, there are those that received loans
from financial institutions other than BAAC, those that
0~6 2 received loans from more than one financial institution, and
7∼15 4 those that received more than one loan from the same
financial institution.
16∼30 8 *2. The amount of the loan was obtained through an interview.
31∼50 12 For BAAC customers, the loan amount was confirmed and
51∼100 11 modified, to the extent possible using a customer list.
*3. Some businesses among the rural non-farm enterprise
101∼499 6 borrowed separate funds for agricultural purposes. These
500 or more 6 figures are not included in the table.
Source: On-site survey
Total 49

This is just one example of an extremely diverse
range of rural non-farm enterprises. This enterprise
manufactured dried red peppers. The business was
begun from drying raw red peppers unsold in the
market to dispose of them.
< Converting unsold raw red peppers in the
market to dried red peppers >
The area near Mr. P’s home, particularly the
eastern district, is land on mountain slopes used
to produce red peppers. Mr. P’s wife originally
bought raw red peppers from farmers and sold
them in the market. Ten years ago, they had dif-
ficulty disposing of the large volume of unsold
peppers, and got the idea of drying them. The
business started when they were successful at
grinding the red peppers, since they had no elec-
tricity, by stepping on them using tools and sell-
ing them in the market. They own four pick-up
trucks. Their sons and daughters drive the trucks
as far as Bangkok and its environs, where they
sell the red peppers. Nowadays, these dried red
peppers are used in cooking as frequently as raw
red peppers, so there is an established market for
the product. The enterprise borrowed money from
BAAC for equipment to dry the red peppers,
machines to grind the peppers (several both large
and small machines in both cases), and for a fa-
cility that is both a plant and a warehouse.
2.4 STRATIFIED FINANCIAL ACCESS
Based on the on-site survey, the following stratifica-
tion can be seen for the access to agricultural loans in
Thailand. The levels at the left-hand side combine
informal funding. As the line moves to the right the
amount of the loans increases11. The characteristics
of the dynamic process of development from a
microenterprise to a small enterprise in Thailand in-
clude using funds acquired informally to start a
microenterprise, saving the proceeds from the enter-
prise after repaying the loan, purchasing land to be-
gin with, and using that land as collateral to formally
borrow money from a bank and expand.
Saving Groups etc. Informal credit
BAAC
Commercial banks
Other governmental financial institutions
The concept of stratified financial access can be
seen in the following reciprocal relationship:
Subsidiary/Auxiliary family enterprise
Enterprise for the family livelihood
Corporate family enterprise
Conventional enterprise

11 Satsaguan (1998) uses the TDRI survey in Nakhon Rachasima as a basis to point out that BAAC is gradually becoming more
important than informal financing. In 1986, the ratio of formal financing to informal financing was 44% to 56%. Of the 44% in formal
financing, BAAC’s share was 18.8%. Ten years later, in 1996, the ratio of formal financing to informal financing was 60.4% to 39.6%.
Of the 60.4% in formal financing, BAAC’s share was 38.8%.
In addition, the scale of informal financing in rural Thailand has rapidly diminished. There are two reasons cited for this. First,
non-agricultural income has become the primary income source for Thai farmers, and the farmers’ income has become more stable than
in the past. Second, BAAC and other institutions providing formal financing have opened branches throughout the country and are
playing an increasingly important role in rural areas.
64 Rural Enterprises Finance : A Case Study of the Bank of Agriculture and Agricultural Cooperatives (BAAC) in Thailand

CHAPTER 3 BAAC FINANCIAL by the BAAC was approved by the Parliament in

SUPPORT FOR RURAL NON-FARM
ENTERPRISES
3.1 THE RAPID GROWTH OF BAAC’S
AGRICULTURE-RELATED FINANCING
Agriculture-related financing was initiated with the
1992 amendment of the BAAC Act. There are broad
interpretations in the field regarding who is eligible
for such financing, and loans already have been pro-
vided in many sectors with the provison that the bor-
rowers be farmers.
BAAC has sharply increased its share of agri-
culture-related financing since 1995. There also has
been financial support from the Asian Development
Bank. As of the end of 1997, the amount of loans to
individual farmers accounted for 6.9% of the total
(Table 6).
There was a significant slowdown in the rate of
year-on-year lending growth after 1997, however, and
in 1998 and 1999, this rate was less than that of the
growth rate in loans to individual farmers for other
purposes. This is attributed to the emergence of the
problem with delinquent loans in mid-1997, and lend-
ing was sharply curbed as a result.
3.2 THE AMENDMENT OF THE BAAC ACT
In a December 1998 Cabinet meeting, the Thai gov-
ernment established a credit line of 40 billion Baht
for loans to medium- and small-sized enterprises from
the Bank of Thailand and government-related finan-
cial institutions. A total of 2 billion Baht was allo-
cated to the BAAC. Further, the amendment of the
BAAC Act that approved non-agricultural financing
1999. The primary points of the amendment are as
follows.
(1) The definition of farmer was expanded to include
spouses, parents, and children of farmers
(2) The definition of non-farm financing was ex-
panded to include industry, commerce, and the
service industry
(3) Financing (medical costs, home building costs)
is provided for training in improving agricultural
technology and for improving the living standard
(4) Financing is provided for joint ventures between
farmers and non-farmers
(5) The ceiling on loan amounts is raised (from 5
million Baht to 15 million Baht)
(6) The range of BAAC sales activities is expanded
(Agriculture-related businesses in addition to de-
posits and lending)
(7) The integration of five sets of rules into one, and
condensing 13 loan categories into five
This amendment continued to confirm and pro-
vide order to the financing, for non-agricultural ac-
tivities, that had been implemented on-site since 1992.
Also, with the passage of this amendment, BAAC
launched an effort after October 1999 to strengthen
the system by such measures as combining agricul-
ture-related financing and non-agricultural financing,
thereby enhancing the inspection and screening pro-
cess with the cooperation of GTZ, the Asian Devel-
opment Bank, and the EU. In the past, each employee
of the business division of the branches had been re-
sponsible for an average of 700 customers, but now
they are arranging to have an average of about 200-
300 customers for both agriculture-related financing

Table 6: The share of agriculture-related loans among all loans to individual farmers (year-end)
Balance of agriculture- Balance of BAAC loans The ratio of Annual growth rate
Year related loans to individual to individual farmers agricultural loans Agriculture-related Agriculture loans
farmers (Baht 1 million) (1) (Baht 1 million) (2) (1) / (2) loans (1) (2)-(1)
1993 ― 75,608 ― ―  ― 
1994 1,580 97,680 1.6% ―  27.1%
1995 4,991 127,243 3.9% 215.9% 27.2%
1996 10,641 162,640 6.5% 113.2% 24.3%
1997 12,325 177,545 6.9% 15.8% 8.7%
1998 13,097 192,823 6.8% 6.3% 8.8%
1999 13,794 222,797 6.5% 5.3% 10.7%
Source: BAAC Annual Report 2000 (Draft)
 JBIC Review No.4 65

Table 7: BAAC interest rate structure*

Customer Category Method for determining Aug/1999 Interest rate Dec/1999 Interest rate
interest rate
(1) Prime (AAA) Three years without an overdue MLR 10.5% 9.00%
(2) Very good (AA) Two years without an overdue MLR+1.00 11.50% 10.00%
(3) Good (A) One year without an overdue MLR+2.00 12.50% 11.00%
(4) General (B) New applicant for a new loan MLR+3.00 13.50% 12.00%
Overdue made and prolongation
(5) Default1 (-) of requital deadline admitted MLR +3.00+1.00 14.5% 13.00%

Overdue made and prolongation

(6) Default2 (-) of requital deadline rejected MLR+3.00+3.00 16.50% 15.00%

Source: BAAC

Table 8: Breakdown of the number of enterprises by the amount of the loan sought

Total all industries Number of enterprises

Amount of loan sought Industrial sector Commercial sector Service industries Total Ratio
0 ~ 100,000 Baht 504 1,339 904 2,747 41.2%
100,000 ~ 200,000 294 613 509 1,416 21.2%
200,000 ~ 500,000 337 730 583 1,650 24.8%
500,000 ~ 1 million 114 240 180 534 8.0%
1 million ~ 5 million 84 125 88 297 4.5%
5 million ~ 10 million 4 8 2 14 0.2%
10 million ~ 20 million 2 0 4 6 0.1%
1,339 3,055 2,270 6,664 100.0%
Total 20.1% 45.8% 34.1% 100.0%
Average amount of loan sought (Baht 1,000) 378 295 319 320 –
Note: It is assumed that all of the enterprises in the above table received part of the funds for expanding their business through a loan.
Based on such an assumption, the number of responding enterprises is classified by the amount of funds they sought.
Source: BAAC

and non-agricultural financing. tor. A breakdown by the amount of financing sought

Also, in August 1999, a system of interest that
doesn’t depend on internal subsidy was introduced
into BAAC. In December 1999, interest rate was
raised to 1.5% (Table 7). On the other hand, although
the cost of non-farm financing is higher than that of
farm financing in general, no more raise has been
made.
3.3 DEMAND FOR FUNDS FOR NON-
AGRICULTURAL ACTIVITIES
BAAC conducted a survey of fund demand for non-
agricultural activities in all provinces from July -
August 1999. Of the 6,887 places of business they
interviewed, 97% hoped to borrow money. A break-
down of the sectors of these places of business shows
that 46% were in the commercial sector, 34% were in
service industries, and 20% were in the industrial sec-
showed that approximately 60% of the rural non-farm
enterprises hoped for loans of more than 100,000 Baht
(Table 8).
3.4 THE POTENTIAL FOR RURAL NON-
FARM ENTERPRISES AND THE ROLE OF
BAAC
As previously explained, BAAC’s agriculture-
related outstanding loan volume is still less than 10%,
yet the survey of fund demand is thought to show a
substantial latent need for funds. BAAC has a wider
national network of branches than either Small-sized
Industry Financial Cooporation(SIFC) or commercial
banks. Also, many of the enterprise households op-
erating rural non-farm enterprises are engaged in en-
terprises for the family livelihood or corporate fam-
ily enterprises that rely exclusively on BAAC for their
66 Rural Enterprises Finance : A Case Study of the Bank of Agriculture and Agricultural Cooperatives (BAAC) in Thailand

formal funding source.
Further, there are thought to be high needs for
assistance in creating business and financial plans and
introducing modern business and production manage-
ment when providing equipment and facility funds in
conjunction with the expansion of the enterprise.
Therefore, a role BAAC could play in promoting ru-
ral enterprises is discovering and supporting promis-
ing rural enterprises and serving as a bridge when
those rural enterprises expand the scope of their op-
erations.
In addition to BAAC, each relevant Ministry
has a fund support program for non-agricultural eco-
nomic activity. In general, however, the scope of
these programs is small and their effectiveness is
limited (Table 9).

Table 9: Financial support and the primary institutions providing financial support for non-farm
economic activities

Institution name Content of support

NESDB Deposits Regional Development Funds (RDF) to the GSB.

Interior Ministry (CDD) Support for forming a savings group.

The group might borrow from BAAC and GSB.

Ministry of Commerce (DIT) (1) Community Stores / Community Business

Loans of operating funds to the group (procurement funds). The loans have no interest,
repayment periods of a maximum of three years, initial loan size of 30,000-50,000 Baht
per loan. It is possible to increase these later to 100,000 Baht.
(2) Agricultural Commodity Market
Financing for private sector businesses that want to establish a market for agricultural
products in regional areas.
The loans have no interest, a repayment term of three years, with a 50 million Baht ceiling
on the loans.

Ministry of Industry Working Capital Fund for Family Enterprise and Handicraft Project
(1) IPC Loans of primarily operating capital to groups or individuals.
(2) PID The annual interest rate is 6%, the repayment period is a maximum of four years, and the loan
size is from 30,000 Baht to 1 million Baht. For loans of less than 100,000 Baht, a guarantee
is needed from a group or two public officers. For loans of more than 100,000 Baht, physical
collateral, particularly land, will be required.

Ministry of Agriculture and
Agricultural Cooperatives (CPD)
These loans provide agricultural cooperatives with training and mutual assistance, water sup-
ply facilities and other infrastructure, and support for funding and technology. Loans to the
cooperatives have 2-6% annual interest (different rates are applied depending on the type of
loan), repayment periods of 1~15 years, and a loan size range of 100,000 Baht to 10 million
Baht for each loan. The interest rates for loans from agricultural cooperatives to members are
an additional 3% on top of the procurement cost from CPD.

Government Saving Bank (1) NESDB’s Regional Development Fund (RDF)

Loans to groups with at least 25 people. As of August 1999, the interest rate was 7%, the
repayment period a maximum of five years, and a loan ceiling of 1.5 million Baht. Other
requirements include joint liability and land collateral.
(2) GSB Social Development Fund
Loans to groups with at least 25 people. Interest rates are based on MLR and are from 10-
12%.
The repayment period is a maximum of five years. The ceiling for RDF loans is 1.5
million Baht. Application for loans in excess of that amount or applications that do not
fulfill the RDF funding requirements will be subject to examination. Other requirements
include joint liability and land collateral.
(3) Loans to medium- and small-sized enterprises (began June 1999). The loan size is over
100,000 Baht with requirement of a collateral.

CHAPTER 4 THE ROLE OF BAAC
AND PROPOSALS
4.1 THE COMPARATIVE ADVANTAGE OF
BAAC AND TASKS FOR THE FUTURE
4.1.1 The comparative advantage of BAAC
(1) The largest branch network in Thailand
During the period from 1980s-1990s, BAAC
worked hard to expand its branch network. Includ-
ing field offices, it now has more than 1,500 offices.
This is a much higher total than the 600-branch net-
works of the second-ranked GSB, which is affiliated
with the government, and the Thai Farmers’ Bank, a
commercial bank. In addition, at this point, IFCT
has only 10 branches and SIFC has just five.
(2) Deposits and lending
BAAC offers both deposits and lending services
in rural areas while providing agricultural financing
at the same time. It has a firm base as a financial
institution. Lending demand has exceeded the tempo
of increase in deposits until now, so it has rapidly
increased its business by receiving long-term, low-
interest loans from JBIC, the Asian Development
Bank, and other institutions, and also borrowing from
commercial banks, while receiving capital infusions
from the government. Deposits have been growing
steadily in recent years, accounting for 34% of the
liabilities of the B/L as of the end of May 1999. Their
reliance on other funding sources is decreasing.
(3) Security system
BAAC has promoted agricultural financing in the
form of the joint liability group. The advantages are
that repayment is ensured by mutual oversight and the
borrower can obtain funds with no security deposits. The
advantage for the lender is that screening can be simpli-
fied. This joint liability group method is an extremely
effective means and has made BAAC loans widespread
and deep-rooted as a funding source in rural areas.
(4) Government support
Not only has the Thai Ministry of Finance taken
a capital stake in BAAC, it also has invested ODA
funds in the bank. It also provides support by allo-
JBIC Review No.4 67
cating 20% of the deposits in commercial banks
through BAAC to financing in rural areas. Under
such state protection, BAAC has grown as a monopo-
listic agricultural financing institution.
4.1.2 Tasks for BAAC
(1) The delay in administrative rationalization
While BAAC has introduced a computer system,
there are still hardware deficiencies, such as a lack of
terminals. In addition, there is still a lot of room for
improving the administrative system itself. Ratio-
nalization of office work, including on-line functions,
is essential in view of reducing costs as well.
(2) Credit Risk Management
Because of the joint liability group system,
BAAC remains weak in its screening process, the most
important task for financial institutions. The bank
needs to strengthen the screening capabilities of its
employees. For expanding their non-agricultural fi-
nancing, they must enhance their inspection of the
assets put up for collateral and establish a system for
disposing of them.
4.2 PROPOSALS FOR THE THAI
GOVERNMENT
(1) Formulating comprehensive measures to promote
rural non-farm enterprises and the promotion of
cooperation by related institutions
It is of the utmost importance that comprehen-
sive measures be formulated to promote rural non-
farm enterprises and to promote cooperation among
the related institutions to provide more effective sup-
port for rural non-farm enterprises.
In this regard, it is worth studying the policy
proposal presented by BAAC in November 1998 for
ties between related institutions. At the central gov-
ernmental level, this called for the establishment of
a Committee for the Joint Promotion of Rural Non-
Farm Enterprises with its secretarial office located
within BAAC. In addition to BAAC, the members
of this Committee would be the Ministries of Fi-
nance, Industry, Agriculture, Commerce, Interior,
and Labor and Social Welfare. The participation of
the private sector also would be sought, including rep-
resentatives of farmer entrepreneurs and NGOs.
68 Rural Enterprises Finance : A Case Study of the Bank of Agriculture and Agricultural Cooperatives (BAAC) in Thailand

In addition, in light of the progress in the decen-
tralization of government power, Joint Promotion
Committees at the provincial level would be estab-
lished with the participation of Provincial Industrial
Office, Industrial Promotion Centers, BAAC branches
and other government financial institutions, represen-
tatives of farmer entrepreneurs, and NGOs. The pri-
mary role of these Committees would be to create a
system for offering an overall program of financing
with technical and business guidance12.
The strong support of the Ministry of Finance
would be required for the establishment of this Joint
Promotional Committee.
It is also necessary to clarify the relationship be-
tween these Committees and National SME Promo-
tion Committee13, which is going to be founded based
on the SME Promotion Act (cleared the diet in Janu-
ary 2000), to be set up in the future.
(2) The role of BAAC in promoting rural non-farm
enterprises
The point could be made that BAAC is the most
effective financial institution providing financial sup-
port to the rural non-farm enterprises discussed in this
paper. It is possible, however, that the area of opera-
tions for Government Saving Bank (GSB) and SIFC
will overlap with those of BAAC in the future14.
Competition with commercial banks is also a possi-
bility. Thus, it is desirable that functions be divided,
such as by all government-affiliated financial institu-
tions establishing lending frameworks (both upper and
lower limits) and assigning roles to elicit the unique
characteristics of each lending institution. Also, it is
desirable to ensure the working of competitive prin-
ciples by overlapping the setting of upper and lower
limits on the loans and allowing several institutions
to make loans in the same sector.
(3) Understanding the current state of rural non-farm
enterprises
As noted before, it can be said that the full and
accurate statistical understanding of the current state
of rural non-farm enterprises has not been obtained.
In the future, when conducting such surveys as the
National Survey of Business Enterprises of 1996-
1997, it would be desirable to incorporate surveys of
all business offices nationwide with more than one
employee in the manufacturing industry, agricultural
sector, commercial sector, and service industry includ-
ing those in rural areas. This would ensure the inclu-
sion of rural non-farm enterprises in all sectors. In
the event of personnel and budgetary restraints, one
possibility would be to select several provinces for a
start and conduct an opinion survey, etc. to determine
the policy needs.
4.3 PROPOSALS FOR BAAC
(1) Enhancing client services15
1) Providing TA (Technical Assistance) through
BAAC
As noted in the foregoing, cooperation with the
programs of the Ministry of Industry and others will
be an important task in the future. At the same time,
BAAC has programs, to foster rural non-farm enter-
prises, that can be utilized independently, linked to
its non-agricultural lending activities. This is expected
to have a specific effect that will encourage the full
operation of BAAC’s function for financing non-ag-
ricultural enterprises.
Not making BAAC itself, which makes judg-
ments on financing, the entity implanting this pro-
gram, but, for example, the Chamnien Saranaga In-
stitute of Agricultural and Rural Development
(CIARD), a subsidiary work of BAAC providing tech-
nical assistance, will be worth examining (Tsuji 1995).

12 In the Nakhon Ratchasima Area Industrial Development Planning Survey conducted by JICA and scheduled for completion by
March 2000, an industrial development plan is to be formulated for Nakhon Ratchasima province and the four surrounding provinces
(Chaiyaphum, Surin, Buri Ram, and one other). It is planned to study these points while linking it with this survey.
13 As for the SME development policy, please refer to JBIC Research Paper No.8-1 (Jan. 2001).
14 Meanwhile, IFCT has a much larger average lending amount, and it is considered that problems are not likely to occur with
BAAC regarding the allocation of roles and responsibilities.
15 ADB is currently providing TA for screening, oversight, and risk management, including enhancing ATM by building and
strengthening an on-line system.

A desirable approach to achieve this would be to start
with a pilot enterprise and gradually expand the range
of the program. It also would be desirable for the pro-
gram to have a balanced content including such busi-
ness expertise as bookkeeping skills, with the produc-
tion technology support provided in the technical as-
sistance.
2) Providing close and detailed advice
As a result of the 1999 amendment of the BAAC
Act, BAAC can now provide lending for education
and medical expenses. It is also necessary to estab-
lish a system for providing various services, includ-
ing financial management advice for household ex-
penses in general, and explanations of the new lend-
ing options, including non-agricultural lending. Con-
sidering the active participation of female entrepre-
neurs in rural non-farm enterprises, it would be worth
thinking about establishing a system in areas with a
high degree of public safety in which women would
be appointed as credit officers to provide very de-
tailed and personalized services.
3) Providing information to farmers
For farmer entrepreneurs, there is a blockage in
conducting these businesses. The problems that could
be cited include the lack of market information and
insufficient marketing.
To deal with these issues, the BAAC Board of
Directors (the chairman is the Minister of Finance)
announced a new policy for BAAC in November
1999. This would (i) provide support for promoting
the marketing activities for the agricultural products
and non-agricultural activities of the farmers; (ii) it
would construct a database system for agricultural
product prices and expenses, etc. for farmers; (iii)
BAAC would establish an information center with
the objective of providing information to farmers.
It could be considered to support the strength-
ening of BAAC’s operations to provide information
to farmers. In that instance, it would be imperative to
cover such aspects as the content of the support it-
16 For example, USAID provided support for creating a system in the Philippines to provide market information for agricultural
products. There were insufficient maintenance and management funds, however, so it has been reported that the system is not operating
as intended.
JBIC Review No.4 69
self, instead of merely providing the physical re-
sources16.
(2) Strengthening the appraisal and supervision pro-
cedures for rural non-farm enterprise financing
The work providing financing to rural non-farm
enterprises, particularly the funds for facilities, will
require such new tasks as formulating business and
fund plans and the screening and monitoring of those
plans. Support for training the employees can be ex-
pected from Japan, the EU, and GTZ, etc. Mean-
while, greater technical cooperation will be sought
from Japan for creating an appraisal and supervision
system, securing on-site operations, and the evalua-
tion of individual cases.
What Japan could do is to dispatch financial
specialists with practical experience through JICA’s
expert system. In this case, it would be most useful
for the experts to have experience with secondary
regional banks, shinkin banks, the People’s Finance
Corp., and the Agriculture, Forestry, and Fisheries
Finance Corp which is the member institutions of
APRACA, described later. To avoid duplication with
the work of other donors, there should be a thorough
coordination in advance regarding the specialists dis-
patched between the Thai authorities and the related
donors concerning TOR.
(3) Reinforcing lending to agricultural cooperatives
The Ministry of Agriculture intends to utilize
agricultural cooperatives as the entity for implement-
ing rural industrialization centered on the processing
of agricultural products. Many agricultural coopera-
tives, however, are incorporated in bureaucratic or-
gans and lack an entrepreneurial spirit. From the per-
spective of cooperation with other organizations, it is
important for BAAC to gradually increase its lend-
ing to selected superior agricultural cooperatives, and
to work with the Ministry of Agriculture and others
to conduct pilot programs, etc. in which the agricul-
tural cooperatives foster initiatives for rural industri-
alization.
70 Rural Enterprises Finance : A Case Study of the Bank of Agriculture and Agricultural Cooperatives (BAAC) in Thailand
(4) Promoting further South-South cooperation
BAAC’s work as a rural lending institution has
earned international acclaim. As previously noted,
CIARD is conducting South-South cooperation in
which the Asian Pacific Rural Agricultural Credit
Association (APRACA) is undertaking training
projects for rural and agricultural financing in other
Asian countries. The scope of these activities is lim-
ited, however. It would be considered significant from
the perspective of South-South cooperation for
CIARD to use Japanese cooperation to convey the
experiences of BAAC, including those from support-
ing rural non-farm enterprises, to such other Asian
countries as Laos, Cambodia, and Vietnam17.
BIBLIOGRAPHY
ADB. 1995. Small Farmer Credit Project.
ADB. 1997a. Rural Enterprise Credit Project in the
Kingdom of Thailand.
ADB. 1997b.Technical Assistance to the Kingdom of
Thailand for Strengthening Project Loan Ap-
praisal and Risk Management of the Bank for
Agriculture Cooperatives.
Ariga, Kenichi and Ejima Shinya. 2000. “Post-evalu-
ation for ODA Loan Project; Kingdom of Thai-
land”, JBIC Review No.2. JBIC.
BAAC. 1993. The BAAC and the European Commu-
nity in North East Thailand.
BAAC. 1998. Annual Report 1997.
BAAC. 1999. Annual Report 1998.
BAAC. 2000. Annual Report 1999 (Draft).
Bank of Thailand. 1998. Financial Institutions and
Markets in Thailand.
European Union and the Ministry of Agriculture and
Cooperatives. 1998. Working with Farmers in
North East Thailand.
GTZ. 1999. Features of Non-farm lending in Kalasin
and Surin.
17 For example, JICA conducted in FY1999 a Survey for Planning Environmental improvements to the Small-scale Rural
Villages in the Impoverished Region of the Mekong River Basin in Laos as the next step for rural development planning survey
projects in Laos. This will study training of the employees of Laotian rural financial institutions in a third country.
Haggblade, Steven and Donald C. Mead. 1998. “An
Overview of Policies and Programs for Promot-
ing Growth of the Rural Nonfarm Economy”,
Paper for the Workshop on Stimulating Growth
of the Rural Nonfarm Economy in Developing
Countries, May 17-21, 1998, Warrenton, Vir-
ginia, U.S.A.
Hayami, Yuji. 1998. “Toward an Alternative Path of
Economic Development: An Introduction”, To-
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and Industry: Selected Experiences from East
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ILO. 1999. “Creating an enabling Environment for
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International Fund for Agricultural Development
(IFAD). 1999. Agricultural Development Bank
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Kiyonari, Tadao. 1990. Chushoukigyou dokuhon (Sec-
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Ledgerwood, Joanna. 1998. Microfinance handbook:
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Meyer, Richard L. 1998. “Rural Financial Markets
and RNFE Development”, Paper for the Work-
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farm Economy in Developing Countries, May 17-
21, 1998, Warrenton, Virginia, U.S.A.
Ministry of Finance, Ministry of Industry and The
Bank for Agriculture and Agricultural Coopera-
tives. 1998. Rural Small and Medium Enterprise
Co-ordination and Support System Program
(Draft).

Nagata, Yoshikatsu. 1996. “Northeast Thailand Vil-
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1986, 1988, 1990, 1992.”, Synthetic Area Stud-
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72 Public Expenditure Management and Developing Countries
Part I: Public Expenditure Management and Development Assistance

PUBLIC EXPENDITURE MANAGEMENT AND DEVELOPING COUNTRIES

PART I: PUBLIC EXPENDITURE MANAGEMENT AND
DEVELOPMENT ASSISTANCE

Kaoru Hayashi*

CHAPTER 1 TREND TOWARDS THE Governance, Institutional Reform Loans (GIRL).1

INTRODUCTION OF PUBLIC
EXPENDITURE MANAGEMENT IN
DEVELOPMENT ASSISTANCE
For several years moves have been apparent towards
the introduction of the public expenditure manage-
ment in development assistance. International finan-
cial institutions such as the World Bank and the Asian
Development Bank (ADB) have made it one of the
points of their policy dialogs with developing coun-
tries, and they have started to implement some tech-
nical assistance and other measures which more nar-
rowly target public expenditure management. The
ADB, which is enthusiastically pursuing public ex-
penditure management, incorporates the following
measures within the concept of public expenditure
management:
Revision of Public Investment Programs (PIP).
Setting three year Medium Term Expenditure Frame-
works (MTEF).
Building contingent debt monitoring systems.
Drafting fiscal and finance-related laws.
Improving internal audit systems.
Introducing computerized data systems into whole
government accounting system.
Introducing and enhancing computerized financial re-
porting within governments.
The World Bank takes a public expenditure man-
agement viewpoint in the preparation and formation
of Public Expenditure Reform Loans (PERL) and
The characteristic point here is that governance
reform and other initiatives and operations for public
sector reform are coming to be understood as inte-
grated elements with public expenditure management.
The process leading to that position begins with in-
creased concern over the outcomes of aid, followed
by consideration of “governance and institutional
capability in the governments of developing coun-
tries” as a precondition for successful outcomes, and
follows through to the positioning of “public expen-
diture management” as a means of building that ca-
pability.
The public expenditure management approach
originated in reforms of the public sectors of devel-
oped countries. From the point of view of making the
management of public sector funds more efficient and
realizing its effects, the fiscal and budgetary targets
are:
(1) Fiscal discipline.
(2) Allocation of resources based on strategic priori-
ties (allocative efficiency).
(3) Effective and efficient use of resources (opera-
tional efficiency).
Public expenditure management is valued as a
specific, basic approach for achieving those roles and
targets. Its concepts and characteristics are defined
by the following:
(a) System building through the introduction of sound
management methods, and the use of those meth-
ods to allocate resources and improve efficiency.

* Deputy Director General, Research Institute for Development and Finance.

1 Arrangement of the concepts of public expenditure management is taken from the 1999 interim report entitled “Public Expenditure
Management in Developing Countries and the Response of Aid Agencies” for the “Survey of Development Policy and Project Assistance”
by JBIC (Consulting House Ltd. Minerva’s Owl and Shinko OMC Inc). (Abbreviated below to “Interim Report”) (in Japanese) .

JBIC Review No. 4 May 2001 pp 72~84

©2001 by Japan Bank for International Cooperation. All rights reserved.

Table 1 Elements, Targets and Specific Methods for Public Expenditure Management
Element Targets
Fiscal discipline • Strong budgetary control
• Control of off-budget funds
Allocative • Budget allocation in line with
efficiency priorities
• Setting of objective criteria to serve
as the bases of fiscal decisions
• Introduction of budgets for each area of activity and of
Operational • More efficient budget disbursement
efficiency • Independence and reinforcement • Empowerment of audit departments
for the management of budget
disbursement departments
Source: Interim Report p.2-5
(b) Shifting the emphasis from the idea of due pro-
cess, which holds that strict observance of rules
and procedures guarantees results, to a new em-
phasis on output and outcomes.
(c) Information disclosure and accountability for the
attainment of targets.
(d) Systematic reforms, including the introduction of
budgets for each type of activity and of accrual
based accounting, and the strengthening of audit
departments.
These ideas are summarized in Table 1. 2
The elements, targets and methods listed above
are certainly not new inventions as individual points,
and most of them have already been developed in tra-
ditional public finance or public corporation theory,
but there are the following two important features:
(a) The roles and objectives of the public sector are
incorporated from the point of view of new insti-
tutional economics, the above elements are col-
lated into three groups, and fund management in
the public sector as a whole is considered.
(b) The “public expenditure cycle” of planning,
implementation and evaluation is emphasized.
The idea of the “project cycle”3 has been estab-
lished in the world of development assistance since
the 1970s, thus the “plan - do - see” cycle is certainly
nothing new, but it is notable that its application has
now been extended to the entire public sectors of de-
veloping countries.
2 Interim Report p.2-5
3 Warren C. Baum, “The Project Cycle,” World Bank/IMF FINANCE AND DEVELOPMENT, Vol.7, No.2, June 1970.
JBIC Review No.4 73
Measures
• Securing accountability through information disclosure
• Adoption of Medium-Term Expenditure Framework (MTEF)
• Clarification and evaluation of policy objectives (project
evaluation, policy evaluation) = grasp of results (outcomes)
• Feedback of evaluation results (fading out of incrementalism
in budgeting and introduction of merit-based personnel
systems)
accrual based accounting
CHAPTER 2 WILL PUBLIC
EXPENDITURE MANAGEMENT
BECOME THE MAINSTREAM IN
DEVELOPMENT ASSISTANCE?
As we saw in the preceding chapter, public expendi-
ture management was in the forefront of the major
movements in development assistance in the 1990s.
There have still not been many actual records of pub-
lic expenditure-type loans (GIRL, PERL etc.), but
there is a strong possibility that direct support for
public expenditure management could become the
major trend in development assistance in the future.
That is the case because public expenditure manage-
ment is, by definition, a comprehensive approach, and
because in recent years the World Bank and other
agencies have started a succession of initiatives cen-
tering on comprehensive assistance.
The Comprehensive Development Framework
(CDF) is one comprehensive approach which pro-
poses that the World Bank should aim to encourage
stronger linkages between aid agencies and countries,
while respecting the ownership of aid recipient coun-
tries. It is a framework for coordination between
multiple stakeholders. In the same way as the DAC
International Development Strategy, it works on the
basis of ownership and partnership to reduce poverty.
Rather than relying solely on macroeconomics, as the
structural adjustment approach did in the past, CDF
conducts it in parallel with analysis of social, struc-
tural and humanistic aspects. The actions of each of
74 Public Expenditure Management and Developing Countries
Part I: Public Expenditure Management and Development Assistance
the domestic and foreign stakeholders contributing
to development, and the actions needed to tackle each
task, are arranged in a matrix, with a time frame of
10~15 years in mind, to build a comprehensive de-
velopment framework4.
Chronologically, the concept of public expendi-
ture management predates the start of the CDF initia-
tive. It is natural that public expenditure management
will be taken up as an effective tool for implement-
ing CDF, because they are both comprehensive ap-
proaches. As mentioned above, CDF is not the kind
of approach that adheres to macroeconomics and
market mechanisms. Instead it aims to bring the in-
stitutional and social elements, which are essential
for the proper function of a modern market economy,
into the framework. The public sector bears the cen-
tral role in laying the social and economic founda-
tions, and its work is achieved through public expen-
diture. Therefore it is reasonable to say that improved
institutional capability, supported by public expendi-
ture management, is the key to the development which
CDF is intended to achieve. The process begins with
evaluation of public expenditure management capac-
ity and identification of shortcomings in each devel-
oping country. The next step is to provide support
measures to improve on the identified shortcomings,
thus raising the state’s overall development capacity
and enhancing the effectiveness of aid5.
Alongside CDF, the relationship between public
expenditure management and the Poverty Reduction
Strategy Paper (PRSP) also attracted attention.The
PRSP is also based on concepts of ownership and
partnership and makes the judgement that develop-
ing countries should make their own economic policy
decisions. On that basis they are responsible for policy
making, which they carry out with support and con-
sultation from the World Bank and the IMF, in a part-
nership which includes the UN, regional development
banks, bilateral aid agencies, NGOs, academia, re-
search agencies, companies and other parties. The
PRSP approach is comprehensive and results-ori-
4 James D. Wolfenson (1999) “A Proposal for a Comprehensive Development Framework”
5 Interim Report pp.3-6.
6 World Bank (2000).
ented. It emphasizes the setting of achievement tar-
gets, the selection of policy methods to attain those
targets, and a comprehensive approach to action on
poverty.
Public policy is of central importance to the re-
duction of poverty. As the public policy concerned is
implemented through public expenditure, it is exactly
the same as the CDF case. The “Source Book”6, which
is the key reference work on PRSP, includes one chap-
ter on public expenditure. It emphasizes the estab-
lishment of public finance rules as a critical path
within the budget cycle. Furthermore, the Source
Book identifies certain common weaknesses suffered
by developing countries in implementing policies for
the reduction of poverty:
- Poor prioritization of investments.
- Unclear compartmentalization between invest-
ment (development) budgets and budgets for re-
current expenditures.
- Shortage of budget for recurrent expenditures
because their budget allocations are not clearly
stated in PIP.
- Inconsistency in the macroeconomic forecasting
which is a precondition for the above.
The Source Book emphasizes the establishment
of public expenditure management cycles, and of pri-
ority for the direction of public expenditure to pov-
erty reduction. Thus PRSP already incorporates in-
herent elements of public expenditure management.
From the above one can easily infer that public
expenditure management will become an important
item on the agenda in development assistance in the
future, as CDF and PRSP converge. There are four
levels for putting it into operation:
(1) Public expenditure management is employed in
policy dialogs with the developing country side
alongside previous country policy (strategy) as
an element in country economic sector surveys.
Alternatively, it can be a added as a perspective
on the preparation and formation of individual
projects.

(2) Addition to the project appraisal items, or reflec-
tion in the implementation methods of the loans.
(3) Provision of T/A and loan, taking into account
policy dialogs accompanied by country-specific
aid policies and country-specific economic sec-
tor surveys, in which public expenditure manage-
ment is treated as one sector.
(4) Based on the policy conditionalities on public
expenditure management, aid can be provided
comprehensively in the form of fiscal support in
line with, or as an element of, structural adjust-
ment facilities.
The first level is actually being carried out in
Public Expenditure Reviews by the World Bank. In
future, in developing countries where CDF and PRSP
are used, they are expected to be merged into one.
However, it is quite likely that individual bilateral
donors will carry on policy dialogs from their own
independent points of view, based on country-spe-
cific aid strategies. That is a valid way of applying
checks and balances as well. In this survey by JBIC,
multiple donors were competing to set performance
indicators and displaying keen interest in providing
aid, but these indicators are the basis for judging
“value for money” and should be regarded as starting
points. There were apparent cases of unbalance in
which not enough attention was paid to raising the
accuracy of costing.7
The World Bank is currently preparing projects
based on (3) and (4) above. In these areas, Japan is
handicapped in all aspects, such as skill and experi-
ence, due to the paucity of its own accumulated ex-
perience of public expenditure management, and is
therefore unable to take the lead in project formation.
As described below, there may be some potential for
the future, but the best way for Japan to proceed for
the time being would be to accumulate experience in
this area by providing co-finance with other donors.
In the formation and appraisal of individual
projects, in stage (2), “public expenditure manage-
7 For details, please refer to the JBIC Research Paper on this survey JBIC Research Paper (No.10 Public Expenditure Management
in Developing Countries).
8 Shinya Ejima and Katsuhiko Nakadate (1998) “Lessons Learned From OECF Post-Evaluation”, Journal of Development
Assistance Vol.5, No.2.
JBIC Review No.4 75
ment considerations” could be developed into a nec-
essary aspect considered alongside “environmental
considerations” and “social considerations”. There
need not be a mutually exclusive choice between the
individual project approach and the fiscal support
approach. Even when projects are carried out indi-
vidually, public expenditure management is an ex-
tremely important element of the policy environment
in which the projects are implemented. If there are
elements in the public expenditure cycle which im-
pede the implementation of a project, the remedy of
such problems should be taken as a benchmark for
the progress made in improving procedures. (2) is the
most familiar field for Japanese ODA. Therefore we
will go on to examine the key points of public expen-
diture management considerations in the implemen-
tation of individual projects.
CHAPTER 3 PUBLIC
EXPENDITURE MANAGEMENT AND
THE IMPLEMENTATION OF
PROJECTS
According to a survey8 carried out in 1997 by JBIC
(then OECF), which examined the specific lessons
learned from project implementation at each stage of
the project cycle, the most common experience at all
stages of the cycle concerned “improvement in insti-
tutional capability”. The stages of the cycle were
“project formation and appraisal”, “management of
procurement and implementation”, “operation and
maintenance”. Of these, the most lessons were learned
from “project formation and appraisal”. Institutional
capability could be called the ability to manage and
use limited resources such as funds, personnel and
information in order to carry out the project. Consid-
ering the fact that most development projects are
implemented through the public sector, the issues of
76 Public Expenditure Management and Developing Countries
Part I: Public Expenditure Management and Development Assistance
organizational ability and public expenditure manage-
ment are two sides of the same coin.
The problems listed below are among those gen-
erally recognized as affecting appropriate resource
allocation and efficient project implementation:
(1) Weak planning capability.
(2) Weakness in the links between policy decision,
plan drafting and budget making.
(3) Weak expenditure management.
(4) Inappropriate budget allocations for maintenance
management (inappropriate recurrent budget al-
locations).
(5) Inappropriate accounting systems.
(6) Inappropriate flows of funds through governmen-
tal structures to lower-tier agencies.
(7) Inappropriate management of foreign aid.
(8) Inappropriate management of cash funds.
(9) Inadequate reporting of fiscal performance.
(10)Inadequate motivation of staff involved in public
expenditure.
The World Bank recognizes from its analysis that
these shortcomings have their roots in structural prob-
lems in budget systems. The structural problems are
as follows:9
(1) Achievement of the goals of budget expenditure
is evaluated solely by the input side, namely how
much money was spent.
(2) The above input targets only consider the short-
term view, with no proper consideration for ap-
parent or latent long-term costs. Furthermore,
when choices arise between capital (development)
investment and recurrent expenditure, or between
financial measures and non-financial measures
(regulatory improvements etc.), there is a strong
bias towards short-term measures.
(3) Budget determination works on a “bottom-up”
basis, which makes it difficult to coordinate be-
tween central government agencies and line-in
agencies in line with policy priorities under an
appropriate fiscal policy. (The costs of dealings
for coordination become extremely high).
(4) Government budget setting tends to allocate any
increase in revenue to new projects.
9 World Bank (1986)
10 Of course, these problems are not confined to developing countries. They are apparent in developed countries, including Japan.
(5) Budget setting by the government, ministries and
agencies tends to concentrate exclusively on fine
tuning of budgets for existing projects (Reviews
do not extend to comprehensive reviews of the
necessity of existing projects).
(6) When expenditure is adjusted up or down part-
way through a financial year, there is a tendency
to make sweeping, uniform cuts from all budget
items.
(7) The application of uniform cuts across all bud-
gets in mid-financial year heightens the uncer-
tainty of policies and budgets in progress, with
the result that ministries and agencies tend to
chase after contingency backup sources of fund-
ing.
(8) The prospect of uniform cuts across all budgets
in mid-financial year gives ministries and agen-
cies a strong incentive to use up their budgets as
early as possible.
(9) There are very few opportunities to make close
inspections of existing projects and projects un-
der way.
(10) Incrementalism in budgets results in very weak
linkages (between central government ministries
and agencies and between the center and the re-
gions) between policies and resources.
(11) Policy implementation and targets lack clarity and
there is a shortage of information on the perfor-
mance of policies, programs and services. There
is also little linkage to their costs, thus informa-
tion on cost - performance is lacking.
(12) As a result of all these problems, there is very
little incentive to improve performance (to use
the budget to attain the objectives of the policy
concerned).
To recap, the problems are concentrated in areas
such as single-year budgets, line-item budgets, “In-
put based” budget appraisal, and incrementalism.10
Among the available tools of public expenditure man-
agement, the single-year budget bias could be coun-
tered by the introduction of Medium-Term Expendi-
ture Frameworks (MTEF). “Input based” budget ap-
praisal could be countered by the introduction of per-

formance budgets (necessitating performance audit-
ing). The line-item budgets, which make it difficult
to introduce performance criteria, can be tackled with
the introduction of activity-based budgets. Perfor-
mance budgets, zero-based budgets and other mea-
sures can be used against incrementalism.
These problems can be arranged in relation to
the implementation of projects, as described below.11
1. GENERAL BUDGETS AND DEVELOPMENT
BUDGETS
In many cases the budget provided for maintenance
management is not enough to do the job properly. The
World Bank’s PER etc. reports that this shortage is a
symptom of the common tendency in developing
countries to put development (investment) budgets
ahead of budgets for recurrent expenditure. Looking
more deeply into the cause, they indicate problems
such as the following:
- There are no policy-based comprehensive frame-
works for whole sector units (such as cases where
no MTEF has been drawn up).
- Cases where allocations for recurrent expenditures
in the medium and long term have been consid-
ered within a Public Investment Program (PIP),
but the fiscal authorities only estimate the alloca-
tions on a yearly basis (Laos PER).
- Cases where recurrent budgets are being squeezed
by subsidies and interest payments on external
borrowing (Indonesia PER).
- Cases where, even in traditional aid projects, the
estimate made of recurrent expenditures at the fi-
nancing stage was inadequate.
The PRSP Source Book emphasizes the poor
linkage between individual project budgets and PIP.
At the beginning, how we can deal with the sepa-
ration of the budgets for development and for recur-
rent expenditures? There have been arguments for and
against this divided (two tier) budget method since
the 1980s or even before. The argument in favor of
the divided budget method is that the ways develop-
11 The World Bank PER summary below was a survey commissioned by Research Institute for Development and Finance, JBIC:
From “Problems with Public Expenditure Management in Five Asian Countries as Seen in World Bank Public Expenditure Reviews”,
by Takayuki Urade, February 2000. (in Japanese)
12 W.C. Baum & S.M. Tolbert (1985) “Investing in Development: Lessons of World Bank Experience”, Oxford.
JBIC Review No.4 77
ment expenditures are incoming and used are clear,
and it is possible to set targets for economic policies
within a balanced budget. The counterargument is that
under the divided budget method, the budget puts
needless emphasis on the construction of physical
facilities.12
Where the objective of each individual project is
its physical completion and the prime concern is to
secure the funding for that purpose, the divided bud-
get method would be advantageous. The upper limit
on the development budget can be simply ascertained
by adding the current account surplus to the amount
of borrowing, thus showing the affordability of
projects. However, this is only an appropriate ap-
proach where the aim is “input” in the form of con-
struction of facilities. From a point of view which
gives greater weight to output and outcomes, or from
the point of view of public expenditure management,
integration to PIP or MTEF is a more desirable stance.
Also, the divided budget method does not easily con-
form to reconstruction of activity-based budgets. Even
if the divided budget method is used, it is important
to incorporate some kind of public expenditure man-
agement framework to secure a recurrent cost financ-
ing for operation and maintenance after the project is
complete.
On the subject of recurrent expenses for projects,
the PRSP Source Book supports the practice of do-
nors incorporating recurrent cost for operation and
maintenance expenses into their aid. In contrast, the
traditional approach to aid, which is followed by Ja-
pan among others, holds that support for recurrent
expenses, once begun, is endless and places a heavy
burden on the donor in later years, as well as harming
the recipient country’s self-help efforts. Even suppos-
ing such assistance is provided, the traditional ap-
proach holds that the increased recurrent expenditures
caused by the implementation of the project should
be supported in a limited and diminishing manner (in-
cremental cost on a declining basis, according to the
World Bank ). However, from a public expenditure
78 Public Expenditure Management and Developing Countries
Part I: Public Expenditure Management and Development Assistance
management point of view, the total activity in each
sector as a whole, including the kinds of activities
mentioned above, including all investment expendi-
ture and recurrent expenditure, is important and the
division between investment and recurrent expendi-
ture has no significance. The activity in a sector could
be, in the example of the irrigation sector, all aspects
of the building, maintenance and operation of irriga-
tion facilities.
Under the traditional approach, finance for op-
eration and maintenance and other recurrent expen-
ditures is impossible, while capital (development)
expenditures for rehabilitation and renewal of facili-
ties can be the subject of aid. However, if there is an
adequate budget for maintenance, there is likely to
be less demand for rehabilitation work. Moreover, the
public expenditure management point of view points
out that if aid is specialized into capital expenditure,
it becomes biased towards the construction of physi-
cal facilities.
Thus it is possible that systems that would be
advantageous for individual projects and would be
preferable for “input” target of aid would not be sup-
ported under public expenditure management.
2. THE POSITIONS OF SINGLE-YEAR
BUDGETING AND INDIVIDUAL
PROJECTS WITHIN MEDIUM AND
LONG-TERM PLANS
In general, even in cases where a developing country
is drawing up its medium and long-term plans, it is
very common for such plans to be only weakly linked
to plans for single year.
The increase in BOT, BOO and other projects
involving private sector activity must also be consid-
ered, In Pakistan, the Public Sector Development Pro-
gram (PSDP) is prepared at the central government
level within its five-year plans, while Annual Devel-
opment Program (ADP) is prepared at the state level.
However, the linkages between the Five Year Plans,
the PSDP and the ADP is weak. Many infrastructure
projects, particularly those on BOT or BOO schemes,
are carried out outside the PSDP, necessitating care
13 See the above-mentioned survey by Urade.
14 ibid.
with the management of contingent liabilities.13
In addition, there are cases such as the following
which are regarded as problems under PER:
- Where the PIP is merely a list of projects (Laos
PER)
- Where the project selection process becomes po-
liticized (with budget battles between ministries
and agencies).
- Where the projects of some parts of the govern-
ment do not require approval from the Planning
Committee and lead to the risk of distortions (Pa-
kistan PER).14
The last case had the advantages of simplified
administrative procedures and greater speed, but would
probably not be supported by public expenditure man-
agement. In cases where there is a high level of depen-
dence on the donor side, coordination between donors
in the drafting of medium and long-term plans and in
setting orders of priority for investments can have a
strong impact on the effectiveness of aid.
3. OFF-BUDGET FUNDS
The approach of aiding individual projects would
support securing of off-budget earmarked funding.
However, as a result, off-budget funds end up squeez-
ing financial resources which should really be tax
revenues. Public expenditure management, which
aims to look at the public sector as a whole, would
give that practice a negative evaluation for its effects
on establishing fiscal norms and allocating resources
efficiently. If system is transparent and accountabil-
ity is guaranteed, the problems can be avoided to some
extent. However, all the PERs take a negative view
on off-budget funds.
In China, debt-related incomes and expenditures
are accounted separately from general account bud-
gets. As a result, the fiscal deficit figures published
by the State Bureau of Statistics do not include gov-
ernment bond expenses and repayment of external
borrowing. The figures for fiscal deficit are therefore
much lower than the real situation. Debts must be
handled with great care in cases where projects are
carried out using off-budget funds. Furthermore, care-
 JBIC Review No.4 79

ful attention must also be paid to “tacit government
guarantees” as a form of contingent liability in the
implementation of BOO and BOT-type projects.
4. MANAGEMENT OF AID FUND FLOW
An on-budget/off-budget system is selected for the
management of aid fund related to the previously
mentioned off-budget funds. When using the on-bud-
get method, the assistance received is calculated as
revenue and its use is calculated as expenditure, and
it is handled as part of the total budget (general ac-
count). On the other hand, when in the off-budget
method, income and expenditure of aid fund is
handled as off-budget fund. When using the off-bud-
get method, there are general problems with the off-
budget system, but there is the advantage that “fungi-
bility” can be avoided to some extent in order to re-
move this from the general account. For example,
China is a typical example of a country using off-
budget management. Here the primary effort for re-
ceiving the aid fund (project formation, response to
donor appraisal) is the responsibility of the executing
agency of the project, and the central government
(Ministry of Finance) has sole control over manag-
ing the debts. The central government’s State Plan-
ning Commission is in charge of maintaining consis-
tency in the nation’s long-term plans. The executing
agency of the project is an entity at the provincial or
city level, and it is common for the relevant project
to be the largest and most important project for the
entity. This means that there is only a very small
chance that the provided funds would be appropri-
ated for some other purpose. The executing agency
has the large “additionality” of “the project can now
be executed because assistance was received”. This
also supports project ownership by the executing
agency.
In this manner there are many advantages in us-
ing the off-budget method from the standpoint of in-
dividual project assistance. There will likely be clear
differences of opinion among donors in whether an
individual project aid approach should be taken or
should budgetary support approach be adopted. The
key points to consider for adopting either the off-bud-
get or on-budget method are the transfer of the aid
funds (how are concessions transferred and who are
the beneficiaries) and, particularly in the case of loan
aid (ODA loan), how will foreign exchange risks be
shouldered. These and other points will be studied in
section 6. Case Study.
5. CENTRAL AND LOCAL FINANCIAL
RELATIONSHIPS
The central and regional financial relationships vary
widely among countries, but generally speaking lo-
cal governments tend to rely heavily on the central
government for financial assistance. Currently, the
decentralization is being promoted, but local govern-
ments have had trouble securing their own sources of
revenues and there are many cases in which they have
met with financial difficulties15. There are also limi-
tations as the local governments lack fiscal restraint.
For example, India has a systematic mechanism for
transferring development expenditures from the cen-
tral government to the states. Still, losses at the State
Electricity Board have weighed on state finances and
have had a negative impact on the capacity to secure
internal funding for development projects for power
and other sectors. The financial relationship between
the central and local governments will be examined
in the following case study.
6. CASE OF AID FUND MANAGEMENT:
INDIA16
In India development funds are allotted between the
central and local governments with the aim of cor-
recting disparities between the regions. Funds are
transferred to the states from the central government

15 Based on the PER (public expenditure review) for each country.

16 The following is from Kaoru Hayashi “Development Assistance Problems in India”, Global Industrial and Social Progress
Research Institute, “21st Century India and International Society”, 1997 (in Japanese). Information on the financial relationships between
India’s central and local governments were referenced from Hiroshi Sato, “Financial Relationships between Central and Provincial
Governments in India”, Institute of Developing Economies, Ajia Keizai (Asian Economy), Vol. 29, No. 5, No. 6 (1988) (in Japanese),
Hiroshi Sato “Financial Relationships between Central and Provincial Governments in India Involving Electric Power Divisions”,
Institute of Developing Economics, Ajia Keizai (Asian Economy), Vol. 32, No. 3 (1991) (in Japanese)
80 Public Expenditure Management and Developing Countries
Part I: Public Expenditure Management and Development Assistance
using the method and based on a fixed formula. Aid
funds are also processed through this system with
money being borrowed (received) by the central gov-
ernment and then allotted to the local governments in
accordance with the planned fund transfer system. The
following is a general overview of this aid fund man-
agement in the 1980s.
(1) The aid fund (both loan and grant aid) is received
by the central government and then transferred to
the state governments and other project execut-
ing organizations.
(2) The transfer from the central government to the
state government is conducted within the “Trans-
fer of Planned Expenditures”. The conditions are
that 70% of the funds are a loan and 30% are a
grant, regardless of the conditions placed on the
original fund (for backward regions only 10% is
a loan and 90% is a grant).
(3) The transfer of funds is in accordance with the
system mentioned in (2) and therefore the funds
are temporarily placed within the general account
to combine it with other “fund allotments” and
then the funds are distributed.
(4) For the target project the state government must
also calculate the receipt and use of aid fund
within the state and central governments’ planned
expenditure budget.
(5) The aid fund is converted into rupees by the cen-
tral government. Therefore, there are no exchange
risks for the state governments.
The following summarizes the rationale behind
this system and shows the general merits for this type
of on-budget management.
(1) Aid fund and development strategies can be eas-
ily aligned because aid projects are included in
the general planned budget allotments. This is es-
pecially true for budget allotments with the aim
of correcting disparities between regions. It is also
possible to have the central government monitor-
ing the progress of the project as part of the bud-
get process.
(2) Unfairness resulting from the different conditions
of the original aid fund can be avoided. For ex-
ample, within the same sector, say irrigation or
afforestation, differences in the levels for execut-
ing agencies and the beneficiaries, as well as un-
fair burdens, can be avoided by providing grant
aid in some area and loan aid in other area.
(3) Support can be given to development projects
carried out by the local governments and their
public corporations under local governments,
which tend to be weaker financially, as the for-
eign exchange risks associated with the loan as-
sistance are shouldered by the central government.
Taking another look at this on-budget manage-
ment from the point of view of public spending man-
agement from the 1990s, it can be highly praised for
helping to plan effective allotment of development
funds. From the point of view of implementing indi-
vidual projects, especially in the case of loan assis-
tance, this system was quite effective in handling for-
eign exchange risks. In other words, the yen loans
are transferred into rupees at the central bank. The
yen is then managed within the central bank’s portfo-
lio. China had adopted an off-budget management
system in which foreign exchange risks were shoul-
dered by the executing agency and eventually the
beneficiaries, and this resulted in the big problem for
them having to repay much larger amounts due to
appreciation of yen since 1993. This is why India
chose a different method.
However, this on-budget management system
used by India has resulted in some problems on the
donor side. It goes without saying that the main prob-
lem has been “fungibility”. The following describes
some of the criticisms that have arisen.
(1) When aid fund is lumped in with the funds being
allotted from the central government to the local
government, there are cases in which funds origi-
nally intended to be grant aid are provided to the
local government and executing agencies in the
form of loans. In other words, the grant aid is
turned into loans (cross subsidization). Some of
the donors providing mostly grant aid are finding
this hard to accept.
(2) Because the aid fund is transferred to general
account, it is difficult to track the flow of the
aid, even if the accounts all balance (fungible in
practice). Furthermore, there is low level of
awareness among the executing agency and the

beneficiaries that “projects are using aid funds”
= “additionality”, and this can hamper incentives
to effectively use the aid funds.
(3) Foreign exchange risks handled by the central
government can result in a type of “hidden sub-
sidy” for the local governments and executing
agencies.
These arguments summarize the problems with
on-budget management of aid funds from the view-
point of assisting individual projects. From the pub-
lic expenditure management approach, these may
be used as a means for discussing and supporting
mid-term public spending plans and other public
spending cycles targeting the overall development
budget. However, India covers such a large area and
has such a large population, and considering the scale
of its economy, it may be difficult to introduce public
expenditure management at the national level. The
Indian government has hammered out a form of
“disintermediation” in which off-budget system is
used for a portion of the aid fund management in re-
sponse to the problems caused on the donor side17.
The main points of this disintermediation are:
(1) Public corporations under the central government
are seen as direct borrowers of the loan aid (guar-
anteed by the central government).
(2) In other cases the central government receives the
aid fund and then transfers it with the same terms
and conditions. This includes transfer of foreign
exchange risks.
Soon after this partial off-budget system was pro-
posed, there were debates both for and against it. It
goes without saying that donors that provide mostly
grant aid were in full support of this proposal. How-
ever, Japan, Germany and other donors that offer a
high percentage of loan aid were quick to point out
problems such as foreign exchange risks. Some of
these points are summarized in the following.
(1) This would effectively close the path to borrow-
ing loan assistance for local executing agencies
17 “Proposals for Promoting Aid Project Implementation” presented by the Indian Finance Ministry for the June 1993 at India
Development Forum
JBIC Review No.4 81
that do not have the capabilities to handle foreign
exchange risks.
(2) This would result in larger disparities between
states with strong financial bases and those with
weaker financial bases.
(3) It would be difficult to apply financial aid in ar-
eas such as major infrastructure projects with long
gestation periods for the capital and in environ-
ments where there is invested poor capacity to
generate direct cash flows. This would all likely
have a negative impact on India’s economic de-
velopment.
(4) Narrowing of the scope of the responsibility of
the central government could undermined moni-
toring functions of the aided project.
In addition to these problems, there are also is-
sues that were initially overlooked (not seen as main
issues). These are related to debt management. By
making many public corporations direct borrowers
through the off-budget method, government debts on
the balance sheet are changed to contingent debts. This
all makes the management of debts even more diffi-
cult. When there are guarantees from the government,
and even when there aren’t, many public corporations
will operate public utilities that can not easily bank-
rupt as this results in a type of “tacit guarantee”. Power
sector is a typical example where many of the Public
Sector Units (State Electricity Boards) are in deficit
due to the politically constrained tariff structure. These
public sector units are “too big to fail” cycle, and
therefore state governments have to continue huge
amount of subsidies to these units.
Clearly there are various practical problems with
budget systems, management of aid fund, off-budget
funds and the financial relationships between the cen-
tral government and local governments. There are no
simple solutions, but it will be necessary to in the
future address these problems within the framework
of the public expenditure cycle and analysis.
82 Public Expenditure Management and Developing Countries
Part I: Public Expenditure Management and Development Assistance
CHAPTER 4 CHALLENGES FOR
INTRODUCING PUBLIC
EXPENDITURE MANAGEMENT
INTO DEVELOPMENT ASSISTANCE
Until now the argument has been along the lines that
“public expenditure management will become the
mainstream for future development assistance”, but
the problems and risks involved in introducing pub-
lic expenditure management into development assis-
tance, as well as mitigation strategies, must also be
addressed.
1. FROM OUTPUT EVALUATIONS TO
OVERCOME EVALUATIONS
Each donor is focusing on the problem of outcome
evaluations and the making of these indexes, which
are directly linked to policy evaluations. However,
the relationship between output and outcome is not a
simple problem. The relationship is shown by the
ADB divisions in Table 2. Outcomes should be
grasped quantitatively, however, it is difficult to make
concrete indexes. One example is poverty reduction
through the DAC new “International Development
Strategy”. In order to achieve this outcome, poverty
being limited to “income poverty”, it is indispens-
able to obtain data. However in almost cases it is very
difficult. Where is the poverty line to be drawn and
how is the poverty of particular social groups to be
handled18? It is also difficult to evaluate the results of
the assistance segregated from total outcome of mac-
roeconomic policies. As a result, even if we try to
grasp the actual outcome of poverty reduction, it is
assumed that we will only be able to make an ap-
proximation with the accumulated output. There has
been a great deal of effort in trying to make outcome
indicators, however, many feel that they are still a
proxy for the true outcome.19
It is important to grasp outcomes and create in-
dexes, but this will all be meaningless unless impor-
tance is also placed on grasping the outputs as well.
18 For difficulties with poverty project formation, see; Hideki Esho, “Development and Poverty”, Journal of Development Assistance,
Vol. 5 No. 4, pp. 46-48, Institute of Development Assistance
19 Interim Report, pp. 2-9
Even if the output is not necessarily always linked to
the outcome, there will be no outcome if there is no
output. Emphasis must be placed on outcomes that
are formed by accumulating outputs through the
steady execution of individual projects. We are now
waiting for actual research to uncover the missing link
between output and outcome.
2. INSTITUTIONAL CAPABILITIES OF
DEVELOPING COUNTRIES
Public expenditure management has the aim of im-
proving the institutional capabilities of developing
countries, but its introduction also limits the country’s
institutional capabilities. When introducing public
expenditure management into a developing country,
the country’s stage of development and other condi-
tions, especially its institutional capabilities, must be
taken into consideration and the advisability and pro-
cedures for such an introduction must also be stud-
ied. This study includes case studies and seminars in
the Punjab Province of Pakistan and in the Philip-
pines as per Part II, two developing countries that have
made considerable progress in introducing public
expenditure management. Through this study many
problems where uncovered in both cases.
Even in these two cases, which have made com-
parative advances for developing nations, it is difficult
to say that public expenditure management has been
fully developed. In particular, the cycle based on the
premise of a performance budget is still far from being
fully developed. If the advanced systems of the devel-
oped nations are simply introduced, it will be difficult
for these systems to become firmly established.
The most important point for the introduction of
public expenditure management in both countries is
that they both had the strong leadership needed for
introducing such a system.
The following are general points of consideration
for introducing public expenditure management into
developing countries, based on the case studies and
seminars.
 JBIC Review No.4 83

Table 2 Examples of Performance Indicators

Sector Type of Indicator
Input Output Outcome Process
Administration No. of staff No. of policy papers Better decisions Openness of debate

Education Student/teacher ratio Retention rates Higher literacy Encouragement of student

expression

Judicial system Budget Cases heard Low appeal rate Assistance for indigent
defendants

Police No. of police cars No. of arrests Decline in crime rate Respect for rights

Corrections Cost per prisoner No. of prisoners Recidivism rate Prevention of abuse

Health Nurses per No. of vaccinations Lower morbidity “Bedside manners”

population

Social welfare Social workers Persons assisted Exits from system Dignified treatment

Source: ADB 1999 p.334

(1) Government leaders who have strong will to im-
prove the public expenditure management need
to be supported in the developing countries.
(2) The introduction of an “Activity Based Budget”
is very useful for identifying the costs of the rel-
evant projects and policies.
(3) Consideration must be given to the tradeoff be-
tween the transfer of authority and accountabil-
ity. Monitoring must be improved.
(4) Policy changes based on feedback from the re-
sults and the accompanying changes in the bud-
get allotment are very difficult areas.
CHAPTER 5 JAPAN’S
DEVELOPMENT ASSISTANCE AND
TACKLING WITH PUBLIC
EXPENDITURE MANAGEMENT
This final section will address public expenditure
management in Japan’s development assistance, fo-
cusing mainly on ODA loans. Public expenditure
management is basically part of the trend towards
budget support, and has been made apparent by look-
ing at this background. However, as mentioned ear-
lier, this is not simply the problem of choosing be-
tween supporting individual projects or providing
budget support. Even when executing an individual
project, public expenditure management is important
in the total process to implement the project and real-
ize effectiveness. Even from the point of view of se-
curing the domestic currency budget, there must be a
strong link between the Medium Term Expenditure
Framework (MTEF) based on the macro-sector com-
prehensive framework, annual budget and individual
project. Emphasis should be given to public expendi-
ture management in the management of financial as-
sistance, and efforts should be made to avoid off-bud-
get financing or use of earmarking.
Support for public expenditure management is
possible, but Japan does not have advanced experi-
ence in this field and thus may have difficulty in lead-
ing such projects at this stage. However, local gov-
ernments in Japan have very strong interest in public
expenditure management and new public manage-
ment20. In the future, the expertise now being gained
by these local government will be mobilized.
There is also the possibility of projects that take
into consideration public expenditure management
reforms in the assistance for individual projects. For
example, there are methods for promoting assistance
and for drafting, integrating capital expenditures and

20 Ohsumi (1999)
84 Public Expenditure Management and Developing Countries
Part I: Public Expenditure Management and Development Assistance
current expenditures, mid-term action plans and fi-
nancing plans based on budgets for each action item
in the sector loan. Proto-type of these loans are al-
ready being implemented21. Monitoring function in
developing countries should be strengthened through
project execution. The World Bank is providing LACI
(Loan Administrative Change Initiative)-type coop-
eration and similar methods are used with its yen loans
(checks expenditure-related documents provided by
the developing country’s auditing organization). There
is room for further expansion in this area, including
training and other components in the future.
It is important to offer active cooperation in cre-
ating performance standards for developing countries.
Specifically, there must be a shared understanding of
operational and effectiveness standards. Dialog and
improvements are possible in coordination with other
donors.
In this manner, support for individual projects
are consistent with public expenditure management.
It is possible to provide support for public expendi-
ture management as an extension of existing assis-
tance tools.
aaaaaaaaaaaaa
21 One example from Pakistan “On Farm Water Management Project” (1992)
REFERENCES
[Japanese References]
Ohsumi S., (1999) “New Public Management - Doc-
trine, Vision and Stragety” Nihon Hyoronsha
JICA (1998), “DAC New Development Strategic
Assistance Research Reports 1-4”.
[English References]
DfID. 1997. “Eliminating World Poverty: A Challenge
for the 21st Century”.
World Bank. 1991. “World Development Report
1991” (Japanese translation: World Bank “World
Development Report 1991 - Problems of Devel-
opment 1991)
World Bank. 1993. “The East Asian Miracle; Eco-
nomic Growth and Public Policy” Oxford
World Bank. 1998a. “Assessing Aid - What Works,
What Doesn’t and Why”.
World Bank. 1998b. “Public Expenditure Manage-
ment Hand Book”.
World Bank. 1997. “World Development Report 1997
- The State in a Changing World” (Japanese trans-
lation: OECF Development Problem Research
Group “World Bank World Development Report
1997, Nation’s Role in the Government” Toyo
Keizai Shinposha, 1998.
Asian Development Bank 1999 “Managing Govern-
ment Expenditure”

PUBLIC EXPENDITURE MANAGEMENT AND DEVELOPING COUNTRIES
PART II: CASE STUDIES22
Taichi Sakano*
Masashi Aoki**
CHAPTER I THE PHILIPPINES
1. BUDGET FORMULATION PROCESS
(1) An Overview
The actual system at present is closer to compliance
budgeting and input-oriented budgeting because of
the disconnect in program structure and administra-
tive structure and difficulties in estimating unit costs
and some loss of expenditure control. On the posi-
tive side, the experiment in performance budgeting
has improved the presentation of the budget and has
increased the performance orientation of budget offi-
cials.
(2) Key Institutions and Organizations
In the Philippines, a number of administrative bodies
are individually and interchangeably play key roles
in the preparation and implementation of the budget.
These are (i) Development Budget Coordinating
Committee (DBCC), (ii) Department of Budget and
Management (DBM)23, (iii) National Economic and
Development Authority (NEDA), (iv) Department
of Finance (DOF), (v) Bangko Sentral ng Pilipinas
(BSP), (vi) Congress and Commission on Audit
(COA), (vii) LEDAC and (viii) Regional level Insti-
tutions.
At the national level, the President steers the fis-
cal policy formulation process through DBCC that
comprises the Secretary of DBM as chairman, with
* Research Institute for Development and Finance
** Research Institute for Development and Finance
22 This part is written mainly on case studies consigned to the study team consisting of Consulting House the Minerva’s Oul and
SHINKO Overseas Management Consulting, Inc.
23 NEDA-ISP (1997), pp.16-19.
JBIC Review No. 4 May 2001 pp 85~92
©2001 by Japan Bank for International Cooperation. All rights reserved.
JBIC Review No.4 85
the Secretaries of NEDA and DOF) and the Gover-
nor of BSP as members. DBM is mandated to assist
the President in the preparation of a national resources
and expenditures budget with the goal of attaining
national socio-economic plans and objectives. DBM
has four main program areas, covering:
1) budget operations , 2) accounting and finan-
cial services, 3) management services, 4) support
services - involving support to DOF’s units in area of
internal management and logistics. NEDA is the eco-
nomic planning agency, with the responsibility of
formulating the medium-term development plan. It
also coordinates the preparation of development plans
in line agencies. The Department of Finance is the
institution charged with ensuring sound and efficient
generation and management of the fiscal and finan-
cial resources of Government. An important link be-
tween the legislative and executive branches of gov-
ernment is provided by the Legislative-Executive
Development Advisory Council (LEDAC) with a
major objective of achieving consistency between
development plans deemed at the executive branches
and law making priorities at the legislative branch.
2. AGGREGATE FISCAL DISCIPLINE
(1) Legal Framework for Budgeting
The legal and institutional framework for budgeting
in the Philippines is well articulated in the Constitu-
tion. The Constitution stipulates that no public money
86 Public Expenditure Management and Developing Countries
Part II: Case Studies
is to be spent without legislative authorization (i.e.,
appropriation), thus by making the Constitution func-
tion as an effective mechanism of budget control. It
also delineates the relative power of the legislative
and the executive branches of government in public
finance. In the Philippines, the power of the purse
that is granted to the legislative branch is counterbal-
anced by the possibility of presidential veto. At the
same time, the Constitution defines the financial re-
lationship between the central government and local
government units (LGUs).
(2) Coordination among Central Ministries
In the first instance, the purpose of the framework is
to ensure that the budget is consistent with the mac-
roeconomic policies and resource constraints. In this
regard, DBCC sets the overall budget obligation ceil-
ing (i.e., maximum expenditures for current and capi-
tal expenditures) based on projections of central gov-
ernment revenues, including ODA, the fiscal deficit
target and upper limit for new borrowings for the year.
In practice, the responsibility for the macroeconomic
projections is fragmented. DOF is responsible for
projections of government revenue, whereas NEDA
for projections of the real sector and prices as well as
ODA flows. BSP for projections of monetary aggre-
gates and balance-of-payment variables. DBCC, with
DBM performing secretariat function, acts as the
clearinghouse that evaluates the different projections.
Nonetheless, this arrangement has oftentimes resulted
in the lack of consistency of the projections.
(3) Fiscal Control
The government, or DMB has two instruments of fis-
cal control, (i) limited issuance of obligation authori-
ties and other measures to keep on the track of fiscal
discipline, and (ii) cash programming. One measure
of the fiscal discipline is for DBM to apply reserves
on agencies’ appropriations by issuing obligation au-
thorities that are less than the appropriation cover as
they appear in the GAA. Another instrument DBM
uses to achieve fiscal control is cash programming.
24 NEDA-ISP (1997), p.45.
In this regard, DBM in close coordination with DOF
prepares the annual program of cash expenditures,
including an Annual Program of Monthly NCA (the
Notice of Cash Allocations) Releases.
(4) WYSIWYG Policy and Notice of Cash
Allocations (NCA)
Starting 1999, DBM initiated a number of reforms in
budgeting with the ultimate goal of establishing line
agencies to speed up the delivery of essential public
services with less paper works. WYSIWYG (What
You See Is What You Get) policy was on a top of
budgetary reform agenda for the current administra-
tion. Under this, the General Appropriation Act (GAA)
serves as the authority of agencies to expend, thereby
having allotment to national/local government agen-
cies released comprehensively every quarter without
the needs for the issuance of the General Allotment
Release Order (GARO). Further, the Notice of Cash
Allocations (NCA) to facilitate payment of due and
demandable Accounts Payables (A/Ps) has since 1999
Budget been released quarterly in lieu of monthly
rations imposed by DBM.
(5) From SPPBS to Medium-Term Expenditure
Framework (MTEF)
(a) SPPBS
The Synchronized Planning-Programming-Budgeting
System (SPPBS) in 1990 was intended to improve
the coordination among the budget, planning and rev-
enue agencies so as to ensure the consistency of bud-
get plans with development goals and available fi-
nance. The concept dates back to the late 1980s. Af-
ter a decade, the general assessment has to be that, in
its own terms, it failed24. Its started objectives are
laudable, but the chosen approach of synchronization
across agencies and regions (with regions in turn syn-
chronizing with LGUs) proved over elaborate.
(b) MTEF (1) Fiscal level and ceiling
These problems was expected to be addressed in the
context of a Medium Term Expenditure Framework

(MTEF). It is regarded as a more appropriate way of
trying to achieve the objectives of the PPBS. The
Government of the Philippines (GOP) embarked on
the budgetary reform in the Budget Call for the
FY2000 that signaled the implementation of MTEF.
The overall objective of MTEF is perceived in the
country to include (i) enhancing planning and bud-
geting linkages, (ii) strengthening fiscal discipline,
(iii) improving allocation of budgetary resources, and
(iv) enhancing agency in program implementation.
In the administrative arena in the country, MTEF
calls for greater integration of the planning and bud-
geting systems involving NEDA, the DBM, and the
DOF. The framework has two salient features, vis-a-
vis, a consistent set of macroeconomic and revenue
forecasts, and forward estimates (FEs) of costs
accruable to the ongoing programs/projects for the
following two years.
MTEF also divides agency’s budget into two
parts, that is, (i) the baseline (or operating) budget,
and (ii) other claims over and above the baseline bud-
get for funding of new programs and projects. The
baseline budget refers to the minimum level of ex-
penditure at which the agency will continue to oper-
ate at the current year’s level and be able to perform
its basic mandate and functions.
3. ALLOCATIVE EFFICIENCY
(1) Prioritalization Procedure
During the preparation of the 1993 budget, the
prioritization strategy was developed by DBCC’s Sub-
committee on Prioritization that was headed by
NEDA, with representatives from DOF, DBM and
the Coordinating Council for the Philippine Aid Plan
(CCPAP) as members. After making provisions for
government-wide baseline budget, the Priority
Projects Fund (PPF) was created and all other agency
activities are lined up against the PPF.
Prioritization for the PPF then followed a two-
stage process. Projects/activities with the following
characteristics were given first priority and are in-
cluded in the agency budget. They are (i) On-going
foreign-assisted projects with an expenditure ratio
(1991 expenditure obligation over budgetary release)
of 60 percent or above; (ii) Projects for completion
JBIC Review No.4 87
in 1993; (iii) Projects/activities tied to program loans
with budget support implications; and (iv) Positive
net revenue generating activities in 1993. In the sec-
ond stage, all other projects/activities not included
under first stage were prioritized based on a point
system with the following criteria: development goal,
regional distribution, source of finance, and imple-
mentation capability.
(2) Limitations on Legislature
The 1987 Constitution provides that “no money shall
be paid out of the Treasury except in pursuance of an
appropriation made by law.” However, it should be
emphasized that there are statutory limitations on the
extent to which the legislature may influence budget
allocation. On the one hand, Congress is not autho-
rized to increase the proposed outlays for each ex-
penditure item included in the President’s budget. It
can only reduce them.
(3) MTEF and Forward Estimates (FE)
(a) MTEF (2) Allocation level
MTEF comprises the following official documents.
It is important to know that MTEF is not only docu-
ments but also is a process.
1) The Medium-Term Philippine Development Plan
(MTPDP) 1999-2004,
2) The Medium-Term Public Investment Plan
(MTPIP),
3) The Medium-Term Macroeconomic Framework
(MTMF),
4) The Medium-Term Fiscal Plan (MTFP), and
5) The Medium-Term Expenditure Plan (MTEP)
The full MTEF implementation mechanism com-
prises the four components, vis-a-vis, (i) budget prepa-
ration, (ii) budget release for major capital expendi-
tures and auxiliaries chargeable against special pur-
pose funds, (iii) contingent liabilities, and (iv) Con-
gressional bills with fund requirements. As noted
above, the transitional MTEF mechanism for the
CY2001 budget requires that (i) the above-the-
baseline proposals include augmentations for exist-
ing programs/projects, and (ii) no saving proposals
being embodied in the light of underestimation of
baseline expenditure.
88 Public Expenditure Management and Developing Countries
Part II: Case Studies
(b) Forward Estimates (FE)
The purpose of forward estimates is rather the deter-
mination of the block allocation for increased mana-
gerial flexibility. In the Philippines, experience of
baseline budget is a good basis for Forward Estimate.
(4) Performance Indicators
All National Agencies and Government Owned and
Controlled Corporations (GOCCs) are requested by
DBM to provide their performance targets and the
indicators applied to measure said targets, normally
by the end of the first month of calendar year for the
ensuing budget. Subsequently, a mid-year review of
the financial and physical performance of those pub-
lic undertakings and entities are carried out by DBM,
while taking into account the Agency’s actual physi-
cal accomplishment and the cost involved in the at-
tainment thereof against the targets committed by each
of the Agencies and NOCCs at the beginning of the
year. The Agency’s performance as gauged during
the mid-year review is to serve as a basis for either
providing for additional allotment from Special Pur-
pose Funds or withdrawal of the allotment already
issued to the Agency.25
4. OPERATIONAL EFFICIENCY
(1) Reengineering Bureaucracy
As dignified in the Budget Call 2000, the government
stressed to improve productivity through the proper
management of the bureaucracy, while recognizing
the urgent need for responsive, streamlined and effi-
cient public service undertaking26. To this end, the
proposed measure gave the President authority to re-
organize all departments, agencies and offices of the
Executive Branch, including government-owned-or-
controlled corporations (GOCCs). The bill also ad-
vocated the adoption of a “scrap-and-build” policy
that is aimed at limiting the creation of agencies.
(2) Performance Evaluation and Costing
(a) Performance Evaluation
Performance Evaluation has to look at both the “Per-
25 DBM (1999a)
26 DBM (1999), p.16
formance” and the “Cost” sides like a Profit and Loss
Statement of an income earning entity in private and
public sectors. In the Philippines, the “Performance”
side involving also the argument which to take “Out-
put” or “Outcome” is now discussed with foreign
technical assistance. To cope with the enforcement
of new budget regulation to impose each agency to
submit performance targets at the time of their bud-
get request and quarterly reporting of the target
achievements.
(b) Costing
In the Philippines, appropriate costing practice is
required in the Executive Order, but the “Costing
System” has not been established. The process of
budget formulation was changed from the Budget
of 2000. Under the new process, an agency is re-
quested to prepare its expenditure program for a
fiscal year without prior knowledge of its budget-
ary ceiling. The indicative ceiling is usually issued
after the agency expenditure program is formulated.
Thus, with no guide on its monetary ceiling, every
agency has to prepare more accurate budget esti-
mation based on rational and justifiable method.
This inevitably requires each agency to improve
their prevailing budget or cost estimation proce-
dures.
(3) Audit
COA is one of the three Constitutional Commissions,
together with the Civil Service Commission and the
Commission on Elections, appointed in the Constitu-
tion of the Republic of the Philippines 1987. Its ma-
jor functions are below.
(i) Auditorial Function
Its function is to examine, audit and settle all
accounts pertaining to the revenue and receipts of,
and expenditures of uses of funds and property owed
or held in trust by, or pertaining to, of all political
subdivisions of the government, such as the provinces,
cities, municipalities, including government-owned
or-controlled corporations. Types of audit that COA

performs are as follows27:
1) Compliance Audit
2) Financial Audit
3) Performance or Value-for-Money (VFM) Audit
Other functions are:
(ii) Rule-making Function; (iii) Reporting Function;
(iv) Recommendatory Function; (v) Limited Account-
ing Function; and (vi) Custodial or Archival Func-
tion
(4) Public Accounting Practices
The public accounting system of the Philippines
would be relatively advanced compared to those be-
ing currently practiced in the rest of the world in terms
of their application of a complete double entry book-
keeping procedure and, even partially, the adoption
of accrual accounting. The accrual accounting being
adopted is what they call “Obligation Accounting
System” in which expenditures are recorded when
incurred regardless the accompanied cash payment,
and the “incurrence” is recognized when “Obligation”
arises.
However, the accrual accounting is not applied
to the Revenue side28. The constitution stipulates that
COA shall have the power, authority, and duty to settle
the government account. Practically for the execu-
tion, all the government agencies must submit their
trial balances and supporting statements, which are
subject to the COA’s audit, and the trial balances are
consolidate by COA into the Government Consoli-
dated Financial Statements, which are submitted to
the President and the National Congress.
Thanks to this accounting system, the govern-
ment is able to prepare a set of financial statements
consisting of the following three statements29.
(i) Balance Sheet (Statements of Financial Position)
(ii) Statement of Operations (Statement of Financial
Position)
(iii) Cumulative Results of Operation
27 COA, “What you need to know about COA”
28 “Accounts Receivables of taxes and other government revenue” do not appear in the Current Assets of the Balance Sheet.
29 This is based on the Financial Statements of FY 1997.
JBIC Review No.4 89
(5) Strength of the Philippine System in
Feedback Function
The important function in the PEM Cycle that is to
be performed is the “Feedback”. Normally the “Feed-
back” is the weakest function, but, in “Feedback Func-
tion”, the Philippine PEM system has a strong ad-
vantage from two aspects listed below.
1) The first strength is the “Resident Auditor Sys-
tem” stated above functioning as day-to-day
monitoring and fostering corrective actions.
2) The second advantage is the disclosure system of
the government performance accompanied by its
evaluation. All the financial and operational re-
sults of every government agency are disclosed
to the public after the approval of the President
and the Congress.
CHAPTER 2 THE PROVINCE OF
PUNJAB, PAKISTAN
1. BUDGET FORMULATION PROCESS
(1) An Overview
The Province of Punjab has started introducing the
“Performance Budget”, which is an ambitious attempt
to apply “Activity-Based Budget”, getting rid of their
conventional “incrementalism” under the “Line-Item
Budget” system. The Province is also leading rest of
the country in the field of Performance Auditing which
plays one of the key roles in Public Management
Reform. This effort has just been introduced and thus
far tried to mainly improve Operational Efficiency,
How Allocative Efficiency will be tackled on provin-
cial level and Fiscal Efficiency can be achieved is the
next step for the reform.
(2) Key Institutions and Organizations
(a) Finance Department
On the introduction of Performance budget, Punjab
90 Public Expenditure Management and Developing Countries
Part II: Case Studies
provincial financial department played an important
role. Punjab provincial financial department advised
all provincial departments to prepare their 1999/2000
budgets as per the revised format, outputs, and in-
puts. Moreover, the financial department planned to
remove from the budget books and process all un-
filled sanctioned posts.
(b) Office of Director General Performance Audit
Wing, Lahore
The Office of Director General Performance Audit
Wing is the development center of Performance Au-
dit and conducts comprehensive training for internal
staff as well as for key officials of whole governmen-
tal sector throughout the country to be involved in
performance evaluation.
(c) Office of Director General Audit, Punjab
While the D.G. Performance Audit Wing is the de-
veloper and trainer of Performance Audit, the execu-
tor is the Office of Director General Audit.
2. AGGREGATE FISCAL DISCIPLINE AND
ALLOCATIVE EFFICIENCY
The principle of the Punjabi budgeting which keeps
the category-wise balance is perfectly sound to em-
phasize proper linkages between the receipts and ex-
penditures based on their respective nature. How-
ever, the distinction between the Current and Devel-
opment budget putting them under different control
prevents the Government of Punjab from efficient
implementation of the new attempt toward New Pub-
lic Management. This issue will be discussed in the
following sections.
3. OPERATIONAL EFFICIENCY
(1) Retrenching Redundant Workforce
On the front of public expenditure, the biggest struc-
tural problem faced by the provisional governance is
the excessive size of their civil service to the resources
available.
(2) Introduction of Public Expenditure Reform
The efforts were materialized as the “Performance
Audit Guidelines” in 1986, which comprises 12 vol-
umes covering auditing procedures for 9 economic
sectors, and the practice commenced. Until last year
(1999), Directorate General Audit, Punjab had per-
formed more than five hundred cases of performance
audit with a wide range. The Directorate General Per-
formance Audit Wing is conducting the training in-
viting not only auditors and other key officials
throughout the country. Along this advanced steps
toward Public Expenditure Management in the au-
diting aspect, a new initiative in the budgeting side,
“Performance Budgeting”, was launched in 1999.
Thus the move toward Public Expenditure Man-
agement, even it is still at an infant stage except for
the area of Performance Auditing, has been proceed-
ing actively leading rest of the country. The Province
has been positively taking in the initiatives and man-
agement techniques for public management provided
by bilateral and multilateral aid agencies like BMB,
the World Bank and ADB during the course of its
progress. However, those momenta seem spontane-
ous rather than imposed and has been led by internal
initiatives as mentioned above.
(3) Performance Budgeting
(a) Outline of Punjab Performance Budgeting
A departure from incremental “Line-Item Bud-
geting” to “Activity-Based Budgeting” is the prereq-
uisite for a “Budget” to carry out its mandated func-
tions: planning and control. The Province of Punjab
introduced in FY 1999 (July to June) the “Performance
Budgeting”, which is a drastic change from their con-
ventional “Line-Item Budgeting”. The “Performance
Budgeting” was applied to the following six depart-
ments to pilot the rest of the Provincial Government.
The underlined phrases clearly depicts that (1)
every department shall specify and propose quanti-
fied performance targets for each activity, and (2) the
budgets are estimated and allocated for these activi-
ties to achieve the targets proposed.
(b) Weaknesses in Punjab Performance Budgeting
i) Imperfect integration of costs under an objective
of an activity.
None of the cost for these activities is included in
the performance budget statement. On the contrary,

performance measures and performance standards
corresponding to the performance budget, that is the
NDF or current costs, do not appear on the statement
except for the minor activities; Reconciliation of ex-
penditure/receipt, Collection of receipts and Moni-
toring of audit paras. According to the Director Gen-
eral Agriculture (Water Management), the perfor-
mance of the NDF is embodied in the physical tar-
gets stated. However, it makes the comparison be-
tween the cost and performance ambiguous. Further,
ensuing operation and maintenance costs accrued to
the completed projects under the non-development
budget (recurrent revenue budget) should be incor-
porated beforehand in development budget, thereby
leading to the medium-long-term fund commitment
to development projects in construction and contin-
ued operation.
ii) Budget estimation with lack of accurate costing
procedures.
The budget estimation is merely based on a rough
percentage allocation of the manpower cost. To im-
prove this situation, the introduction of accurate cost-
ing system is needed.
iii) Lack of cooperation with the Department of Au-
ditor General
The public auditing by Directors General of Au-
dit, Punjab is very strong among the functions of PEM.
They are the professional source of performance
evaluation and accounting. The new attempt of the
Performance Budgeting would not be successfully
established and operated without the Punjabi audi-
tors’ expertise and cooperation. However, there is no
sign or intention in the Finance Department who has
been leading the Performance Budgeting to involve
the Department of Auditor General in the region.
(4) Performance Auditing
(a) Framework of Performance Auditing
The Performance Audit Guidelines issued in 1986 was
further enriched into the new Performance Audit
Guidelines in 1993 absorbing the results and lessons
of the practical performances in this field.
The new Guidelines have been enriched in terms
of its comprehensive coverage, principle and practi-
JBIC Review No.4 91
cal auditing procedures, expanding its old scope cov-
ering nine economic sectors to accommodate more
detailed conceptual framework with extended sectoral
coverage including social and environmental aspects.
The new Guidelines consist of two separate catego-
ries. The contents of each are as follows.
(b) Practice of Performance Audit
The auditors of the Office, together with consultants
hired to evaluate technical issues and project evalua-
tion. Conducting a) review of project documents
completion and evaluation reports by various agen-
cies, b) interviews with the beneficiaries and c) site
visits and physical inspection of the project facilities,
the team performed the audit from comprehensive
viewpoints including technical, financial, economic,
managerial and social aspects. Accordingly their find-
ings and recommendations cover quite a wide range
of important issues.
The Performance Auditing is judged consider-
ably strong among the elements of PEM in the Prov-
ince of Punjab in terms of not only its institutional
framework but also the practices conducted especially
in the fields of project and programme auditing. How-
ever, it is supposed that the auditing could not exer-
cise their full capacity due to the lack of Performance
Statement in the Pakistani public accounting system.
The issue of the Performance Statement will be re-
viewed in the context of Punjab PEM from the ac-
counting viewpoint in the later section.
(c) Project Evaluation by the Provincial Government
Performance Evaluation is carried out by recommen-
dation of the Finance Department and at the request
of the department in concern for the completed
projects. Largely due to a paucity of staff, budget,
and time, project evaluation take place selectively,
not all of the completed projects. In the Forestry sec-
tor, ten projects have been evaluated thus far in this
fiscal year, of which three projects have been recom-
mended to terminate, or alternatively saying, disquali-
fied for ensuing allocation of operation and mainte-
nance non-development budget.
In due course of evaluation, the criteria are usu-
ally applied which include, among others, (i) compli-
ance with PC-1utilization of funds allocated, (ii)
92 Public Expenditure Management and Developing Countries
Part II: Case Studies
physical achievements, (iii) compliance with the
policy objectives of the project, and (iv) meeting the
policy target of the Provincial Government that in-
cludes the increase of income level of the beneficiary
people. Duration of project evaluation is somewhere
around a couple of weeks at minimum and a couple
of months at maximum.
(5) Multi-Layered Evaluation System
A well organized multi-layered control system was
observed for its performance evaluation. The fol-
lowing is the system from internal control within
the Office of Director General Agriculture (Water
Management) Punjab, to the Office of Director
General Audit.
(6) Public Accounting System
An Accounting System is a major provider of mon-
etary information to every stage (except Feedback)
of a PEM Cycle, and double-entry bookkeeping pro-
cedures and accrual-basis accounting are important
and effective functioning. Additionally, a Perfor-
mance Statement must be one of the main compo-
nents of Public Accounting together with financial
statements for the Evaluation stage as well as to carry
out the public accountability.
In Pakistan, the Department of Auditor General
aaaaaaaaaaaaa
is preparing a new public accounting system under
the World Bank technical assistance entitled “Paki-
stan Improvement to Financial Reporting and Audit-
ing Project (PIFRA)” to be adopted throughout the
country. The system itself is sophisticated based on
the double-entry and accrual accounting, however it
has a weakness as public accounting in a sense that it
only covers financial statements and omits prepara-
tion of a Performance Statement.
REFERENCES
Commission on Audit (COA). (no published year).
What you need to know about COA. COA, Ma-
nila.
Department of Budget and Management (DBM).
1999a. 1999 Performance Accomplishment Re-
port, 1 January to 30 November. DBM, Manila.
Department of Budget and Management (DBM).
1999b. FY2000 Budget Program Executive Sum-
mary. DBM, Manila.
National Economic and Development Authority –
Institutional Strengthening Project (NEDA –
ISP). 1997. Philippines – Systems and Gap
Analysis. NEDA, Manila.

APPLIED GENERAL EQUILIBRIUM ANALYSIS OF EAST ASIAN GROWTH1
Minoru Ono*
SUMMARY
This paper examined how several changes in the East
Asian region had an impact on these economies and
their industrial structures before and after the currency
crisis by using an applied general equilibrium model.
First, to study whether export-led industrializa-
tion can singly lead to growth, the paper made an
explicit account of the mechanism in which industri-
alization makes way for a service economy. In the
process, it was shown that it is increasingly impor-
tant for NIES to get along with the predominance of
the service sector. Second, as robust export expan-
sion may be considered as the primary factor behind
their recovery since 1999, the effect of currency de-
preciation on the real economy was estimated in the
countries and its impact on the recovery process was
evaluated. Finally, given a prevailing view that the
V-shaped recovery has put an end to the crisis, this
paper examined the effect of investment which has
fallen significantly after the crisis on their potential
economic growth.
INTRODUCTION
One characteristic that sets East Asian economic
growth apart from others is that high growth was sus-
tained for more than 30 years. In particular, fast
growth was observed in NIES and ASEAN countries.
Latin America experienced rapid growth in the 1970s,
but its growth has decelerated considerably in the
1980s. There is hardly a region that experienced sus-
* Senior Economist, Research Institute for Development and Finance (RIDF), Japan Bank for International Cooperation
1 I gratefully acknowledge detailed comments from Kanemi Ban, Professor of Osaka University, during the workshop on November
28, 2000. I am also grateful to the staff of RIDF for their helpful suggestions. However, I am solely responsible for any remaining errors
in the paper.
JBIC Review No. 4 May 2001 pp 93~
©2001 by Japan Bank for International Cooperation. All rights reserved.
JBIC Review No.4 93
tained high growth like East Asia.
However, the currency crisis descended on Thai-
land in the summer of 1997. This triggered similar
crises later in Korea, Indonesia, and so on. Econo-
mies previously admired for high growth exposed a
number of vulnerabilities, thus registering a sudden
change with substantial negative growth in 1998.
Entering 1999, the economies affected by the
currency crisis have rapidly recovered. However, the
question remains as to whether they will be able to
continue high growth as in the pre-crisis years. This
paper used an applied general equilibrium model and
examined how several changes in the conditions sur-
rounding growth in the East Asian region have made
an impact on these economies and their industrial
structures before and after the currency crisis.
An applied general equilibrium model has an
advantage in analyzing intra-market or inter-market
transactions of economic units such as utility maxi-
mizing households and profit maximizing firms.
Macro-econometric models are effectively used for
economic forecasts and analyzing the effect of eco-
nomic measures on macroeconomic variables such
as output and employment, given the observed rela-
tionships between variables in the past and the as-
sumption of stable economic structure. On the other
hand, applied general equilibrium models can quan-
titatively evaluate the effect of a change in economic
policies on industrial structure, allocation of resources
and income distribution, as it affects relative prices
and leads to corresponding changes in the behavior
of economic units. This is a characteristic not found
in macro-econometric models. This technique may
94 Asian Crisis, Financial Reconstruction and Incentive Mechanism
well find a wide range of uses, including an analysis
of not only the economy-wide effect of trade liberal-
ization through a change in tariff regime but also the
effect of economic structural reform designed to rem-
edy the regulation-induced distortions.
An applied general equilibrium model was used
in this paper because structural change in the economy
is deeply involved in growth in this region and thus
one cannot discuss the prospect of the Asian economy
without this consideration.2 The model used here has
the industrial sector disaggregated into specific cat-
egories, providing a major advantage for studying
growth when structural change is underway. To the
extent that it is a comparative static model, it can only
capture a shift in equilibrium levels of variables.
However, assuming that structural change is taking
place constantly in Asia, equilibrium levels of eco-
nomic variables keep shifting, and this model may be
used as an analytical tool.
This paper consists of the following sections.
Chapter 1 deals with industrialization policies. East
Asian countries aimed at industrialization led by ex-
ports. In the process of growth, they successfully
transformed themselves from an agricultural or natu-
ral resource-producing region to an industrial prod-
uct-producing region. However, the share of the
manufacturing sector and the export-output ratio have
already reached high levels, and Japan and NIES have
large increasing service sectors. Thus a question arises
as to whether export-led industrialization can singly
lead to growth. The study made an explicit account
of the mechanism in which industrialization makes
way for a service economy, and examined how in-
creased consumption resulting from an expanding
economy affects industries and individual economies.
Chapter 2 deals with the effect of an extraordi-
nary depreciation in the exchange rate in the after-
math of the Asian currency crisis. Despite a signifi-
cant economic downturn immediately after the cri-
sis, the East Asian economy has registered a sharp V-
shaped recovery since 1999, which was well beyond
expectations. One of the major factors behind it seems
to be a robust growth in exports. Capital outflows
2 Ito et al.(2000) discussed that the structural change has a profound relevance in Asian economic growth.
after the crisis caused exchange rate depreciation,
which adversely affected the financial sector with
soaring non-performing assets, but contributed to the
real economy with an increase in exports. In this sec-
tion, the effect of exchange rate depreciation on indi-
vidual economies and the extent of impact on their
economic recovery were examined.
Chapter 3 considers the effect of a change in in-
vestment activities after the crisis. A rapid pace of
capital accumulation provided underpinnings for high
economic growth in East Asia. However, after the
crisis, investment declined sharply, and there was a
turnaround in international capital movements from
net inflow to outflow. While a prevailing view is that
the V-shaped recovery has put an end to the crisis,
one may note a clear difference in the pattern of
growth before and after the crisis. The current state
may simply be considered as an upturn in economic
activity in reaction to the major economic downturn
and, in particular, an upturn in foreign demand. This
section examined how potential growth rate would
have been affected by the assumption that investment
activities did not recover.
CHAPTER 1 GROWTH BASED ON
EXPORT-LED INDUSTRIALIZATION
1. INDUSTRIALIZATION POLICIES IN ASIA
Probably no one will argue against the point that it
was successful industrialization policies that enabled
East Asian economies to take off to the fast growth
path. Though initially they were agricultural or re-
source producers, except Hong Kong and Singapore,
East Asian countries started to adopt policies for in-
dustrialization in the 1950s and 60s. Industrializa-
tion proceeded by undergoing several stages. This
sequence may be roughly summarized as follows.
The first step toward industrialization for most
developing countries is import substitution. Its pur-
pose is to: first, reduce current account deficits by pro-
moting domestic production of imported industrial
goods; and second, absorb a vast pool of domestic

labor surplus. East Asia achieved a measure of eco-
nomic growth with domestic production induced by
the policy of import substitution. Because of their
small-sized economy, however, their growth soon
faced an impasse. The downside of import substitu-
tion was that steep tariffs and quantitative import re-
strictions protect domestic industries by making them
immune from international competition, which leads
to a high-cost economic structure and sluggish im-
provement in industrial productivity. Furthermore,
in the absence of domestic agglomeration of inter-
mediate and capital goods industries, as industrial-
ization proceeded further, more intermediate materi-
als and capital goods, such as equipment and machin-
ery, had to be imported. Thus this policy did not pro-
duce initially expected results in slashing current ac-
count deficits. NIES and ASEAN countries recog-
nized these limitations at the early stage and made a
major policy shift toward industrialization through
promoting exports. This resulted in sustained high
economic growth in later years.
Making a turnaround to an export-oriented
economy, East Asian countries sought sources of de-
mand in overseas markets, which were far larger than
their domestic markets, and were able to increase pro-
duction to the maximum extent that they could ex-
pand their supply capacities. Many countries em-
ployed not only industrial policy but also trade, for-
eign exchange, and financial policy to boost exports,
while setting in place import substitution policy. High
tariffs and quantity restrictions on intermediate goods
therefore became a drag in promoting exports. In an
effort to keep up with international competition, gov-
ernments took such preferential measures for the ex-
port sector as lower tariffs on intermediate goods and
the allocation of import quota for those exporters with
good export records. While the export sector received
favorable treatment, the industries aiming at the do-
mestic market were left in the cold, thereby giving a
strong momentum to a shift to an export-dependent
industrial structure. Since the mid-1980s, Korea and
Taiwan saw an increasingly tough export environ-
ment, due to appreciation in their currencies, wage
hikes, growing protectionism in the industrial coun-
tries and developing countries gaining on them. In
the area of trade, individual economies in the region
JBIC Review No.4 95
reduced tariffs and pushed forward import liberaliza-
tion. And liberalization in the capital market moved
forward step by step, accelerating the overall trend
for liberalization.
As industrialization proceeded smoothly prima-
rily in the light industries, and the economies gained
strength, some countries tried to develop the heavy
and chemical industries. One purpose was to add, as
an extension of import substitution policy, interme-
diate and capital goods to the list of domestic prod-
ucts, which had been hitherto dominated by consumer
goods. The other purpose, motivated by export pro-
motion policy, was to shift exports to more value-
added heavy and chemical industries. The heavy and
chemical industries, however, are capital intensive,
and thus require huge amounts of investment. Given
meager capital resources in the private sector, the
public sector had no choice but to play a significant
role in the developing countries, whether it directly
undertakes or indirectly assists the private sector. This
is the reason that not all the developing countries could
take this route, and some of those who dared had to
backtrack in the midway, unable to shoulder the heavy
financial burden.
2. TRANSFORMATION OF INDUSTRIAL
STRUCTURE
As a result of industrialization policy, East Asian coun-
tries enjoyed high economic growth over a long pe-
riod of time and underwent a drastic change in the
industrial structure, the focus of which shifted from
agriculture and natural resources to manufacturing.
According to neoclassical growth theory, a structural
change has only a temporary effect of shifting the level
of output, but is not a factor for changing growth rate
over a long time. In East Asia, however, structural
change itself continued to take place one after an-
other, bringing about a sustained increase in the level
of production, thus helping to achieve a robust eco-
nomic growth.
Table 1 shows the growth rate of total value added
per employment by industry. An interesting point here
is the bold-faced figures for Korea, Taiwan and the
Philippines in the second half of 1980s and for Indo-
nesia, Malaysia and Thailand in the first half of 1990s.
The growth rate in the industries as a whole surpassed
96

the comparable rate in each individual industry. In
the absence of a change in industrial structure, it would
be impossible for the overall growth rate to exceed
individual growth rates in the primary, secondary and
tertiary industry, since the former is a weighted aver-
age of the latter. However, this is not necessarily the
case if the employment pattern has changed. What
actually happened in East Asia was that labor force
migrated from the primary industry, where labor pro-
ductivity was low, to the secondary and tertiary in-
dustries, where productivity was high, thereby boost-
ing the growth rate of economy-wide productivity3.
The figures in Table 1 reveal that even when la-

Table 1 Growth of Value Added Per Employment (annual, in Real Terms)

(%)
Japan 1970∼75 1975∼80 1980∼85 1985∼90 1990∼95 Indonesia 1970∼75 1975∼80 1980∼85 1985∼90 1990∼95
Agriculture 8.3 0.2 4.7 3.3 1.7 Agriculture 10.4 −0.1 −0.9 5.4
Industry 3.2 3.5 2.5 4.4 0.5 Industry −0.7 1.1 3.8 2.1
Manufacturing 4.0 5.0 3.6 4.1 1.5 Manufacturing 9.7 8.2 4.9 3.7
Service 2.8 2.6 1.8 1.9 0.7 Service 6.4 2.6 4.9 2.9
All Industries 4.0 3.2 2.4 3.1 0.8 All Industries 9.4 1.7 3.0 6.2

Korea 1970∼75 1975∼80 1980∼85 1985∼90 1990∼95 Malaysia 1970∼75 1975∼80 1980∼85 1985∼90 1990∼95
Agriculture 2.7 0.5 11.0 3.1 6.8 Agriculture 3.8 4.3 4.5
Industry 3.1 5.6 6.9 5.7 6.6 Industry 2.4 3.2 4.9
Manufacturing 6.1 7.1 7.3 5.8 8.7 Manufacturing 3.1 3.9 6.9
Service 4.4 0.2 1.5 4.8 2.5 Service −1.0 1.1 5.3
All Industries 4.0 4.0 6.2 5.9 4.9 All Industries 1.7 3.3 5.8

Singapore 1970∼75 1975∼80 1980∼85 1985∼91 1991∼95 Philippines 1970∼75 1975∼80 1980∼85 1985∼90 1990∼95
Agriculture 6.5 7.1 8.1 1.8 4.5 Agriculture −2.0 1.9 −2.9 2.5 −0.7
Industry 3.2 2.0 2.4 4.1 9.9 Industry 7.4 2.2 −5.3 1.1 −1.3
Manufacturing 1.6 3.5 1.5 5.6 10.1 Manufacturing 4.8 1.8 −3.9 2.4 −1.2
Service 4.4 3.2 3.6 4.6 4.1 Service 4.1 0.6 −4.5 1.8 −0.4
All Industries 4.2 2.9 3.2 4.4 6.0 All Industries 2.7 2.0 −4.6 2.6 −0.5

Taiwan 1970∼75 1975∼80 1980∼85 1985∼90 1990∼95 Thailand 1970∼75 1975∼80 1980∼85 1985∼90 1990∼95
Agriculture 1.0 8.5 1.3 5.8 2.7 Agriculture 8.1 −3.8 2.5 0.8 6.9
Industry 2.9 5.6 4.5 5.3 4.6 Industry −6.0 6.7 0.3 7.2 2.1
Manufacturing 1.5 6.9 4.5 5.7 6.5 Manufacturing −6.7 8.2 −0.1 8.0 3.8
Service 5.4 3.8 3.2 6.5 4.2 Service 0.2 3.8 −0.8 6.2 1.9
All Industries 4.9 6.9 4.1 6.8 4.8 All Industries 6.7 1.1 2.6 6.5 7.4
Sources: World Development Indicators, World Bank; Yearbook of Labor Statistics, ILO; Taiwan Statistical Data Book,
Council for Economic Planning and Development, Taiwan.

3 Let total value added per worker be Y, its rate of change y, the share of workers in the particular industry relative to total labor
force S, and its change ∆ S. Further, let figures, 0, 1, 2 and 3 denote respectively the total economy, the primary, secondary and tertiary
industry. Then,
y0 = {(S1*Y1/Y0)*y1 + (S2*Y2/Y0)*y2 + (S3*Y3/Y0)*y3} ........................... (Labor productivity effect)
+ {∆ S1*(Y1/Y0) + ∆ S2*(Y2/Y0)+ ∆ S3*(Y3/Y0)} ............................. (Structural change effect)
+ {(∆ S1*Y1/Y0)*y1 + (∆ S2*Y2/Y0)*y2 + (∆ S3*Y3/Y0)*y3} ........... (Residual)
where Y0 = S1*Y1+S2*Y2+S3*Y3 and ∆ S1 + ∆ S2 + ∆ S3 = 0
When changes in share and labor productivity are small in each industry, the residual of the above equation may be ignored. Then,
a change in the economy-wide labor productivity is the sum of increases in labor productivity in the respective industries and the effect
of structural change. Structural change contributed 0.8% to annual growth in Korea, 0.7% in Taiwan and 0.8% in Philippines during
1985-90; 3.0% in Indonesia, 0.7% in Malaysia and 4.6% in Thailand during 1990-95.

bor productivity did not improve in individual indus-
tries, structural change (or more advanced industrial
structure) could lead to growth in the overall labor
productivity. In Asia, structural change was one of
the factors behind high growth. Needless to say, a
factor on the demand side that made structural change
possible in the respective East Asian economies was
the expansion of exports. Had there been a constraint
in demand growth, a larger production capacity would
have simply ended up in increased inventories. It is
because they turned to overseas for sources of de-
mand that they achieved rapid growth without being
hampered by the limited domestic purchasing power.
In order to attain high growth, the governments had
only to address ways to expand production capaci-
ties. Simply by concentrating the resources in the
export-related industries, they could transform them-
selves into industrial economies. The export-GDP
ratio was traditionally high in Hong Kong and
Singapore because they were transit trade ports, but
this ratio soared in Korea from 14.1 % in 1970 to
40.2 % in 1987, and in Taiwan from 30.3 % in 1970
to 52.4 % in 1985, indicating their rapidly increasing
dependence on exports up to the 1980s. Entering the
1980s, ASEAN countries continued to register steep
increases in their export-GDP ratios. From 1980
through 1985 it rose from 57.5 % to 95.4 % in Ma-
laysia, from 24.1 % to 41.7 % in Thailand, and from
23.6 % to 36.4 % in the Philippines, though it de-
clined in Indonesia, a largely resource exporting coun-
try, during this period. Export structure also changed,
with primary products giving way to industrial prod-
ucts as the mainstay of exports. The share of indus-
trial products in exports, which was around 20 % in
1980, increased to over 70 % in 1995 in Malaysia
and Thailand, and to 40 - 50 % in Indonesia and the
Philippines.
3. MODEL SIMULATION
(1) Introduction
ASEAN countries experienced sustained eco-
nomic growth driven by progress in industrialization
up to the eve of the crisis. Although industrialization
4 The World Bank (1993) argues that an increase in total factor productivity contributed significantly to East Asian growth,
whereas Krugman (1994) presents a negative view on its contribution.
5 Economic Planning Agency (1999)
JBIC Review No.4 97
also proceeded in Japan and NIES during the high
growth period, the share of the manufacturing sector
has declined in Japan since the first oil crisis, and in
Korea, Taiwan and other NIES since the second half
of 1980s. In Japan, despite consistent growth in per
capita GDP, the share of manufacturing in GDP
reached a peak of 36.0 % in 1970 before the first oil
crisis and thereafter gradually declined to 24.3 % in
1996. Likewise in Korea, the share of manufactur-
ing fell from 32.1 % in 1988 to 25.9 % in 1996, and
in Taiwan from 39.4 % in 1986 to 27.9 % in 1996. In
Singapore and Hong Kong, the similar share also took
a downturn from a peak in mid-1980s.
Industrialization that proceeded in individual
countries and regions was considered to be the driv-
ing force behind growth in East Asia. However, after
a certain point in time, it appears that income was
rising even if industrialization was taking a step back-
ward. This raises a question as to whether economic
growth driven by industrialization is sustainable.
With the use of growth accounting, sustained high
growth over a long period in East Asia may be bro-
ken down into three factors: rapid accumulation of
capital stock; abundant labor force; and technical
progress (an increase in total factor productivity
(TFP)). There are divergent views on the question of
whether growth in TFP made a significant contribu-
tion.4 However, broad consensus exists over the con-
tribution of an increase in capital stock and labor force
to growth.5
Capital stock increased in response to robust in-
vestment demand mainly from the export-oriented
industry, supported by growing domestic savings and
capital inflows from overseas. Saving ratios in East
Asian countries are very high, and they are charac-
terized by a large share of public sector savings and
substantial savings in the corporate sector rather than
in the household sector. The corporate sector holds
larger export profits and spends them for their invest-
ments. Further, the manufacturing sector could ex-
pand production by absorbing labor from agriculture,
the sector where there is surplus labor.
As long as there is labor surplus, the goods-pro-
98

ducing sector and the service sector may expand pro-
duction simultaneously. Once labor shortage appears,
however, competition for obtaining labor raises wages
further. If the rate of wage increase exceeds the
growth rate, the labor share in National Income will
increase, raising household income and thereby
sharply boosting demand for services. At the same
time, wage hikes also tend to degrade the international
competitiveness of the labor-intensive manufacturing
sector, which, in turn, will put a brake on export
growth. Frequent explanation for increased share of
the service sector in the economy is that since the
consumption of services is highly income elastic, in-
come growth raises their relative share in the
economy.6 As the composition of consumption de-
mand, where spending on the service sector accounts
for a predominant share, differs substantially from that
of export demand, where goods have a dominant
share, a rise of the labor share will dramatically ex-
pand the service industries. In Taiwan and Korea,
the real wages in the manufacturing sector rose by an
annual rate of 10 % or more during the second half of
the 1980s, and an attendant sharp increase in the la-
bor share bolstered consumption. Japan had already
witnessed a rapid growth of labor in the first half of
the 1970s, resulting in a growing share of its service
sector in total output. Booming consumption appar-
ently led to a shift in industrial structure (toward the
dominance of the service sector in the economy).
In an attempt to examine this stylized explana-
tion, a simulation using an applied general equilib-
rium model finds the effect of an increase in total
consumption expenditure (household consumption +
government consumption) on the economy and in-
dustries. The following simulations see the effect of
one percentage point increase in the consumption ra-
tio (the percentage share of total consumption in GDP)
in the four countries—Korea, Taiwan, Malaysia and
Thailand.
(2) Simulation
Since the structure of the ORANI-G Model used
in this paper has already been described in Horridge
et al. (1998), only a brief explanation is given below
to the extent that there is relevance to the simulation.7
The database of the GTAP Model, a global model,
was converted to be used for the ORANI-G Model,
single region model. The simulations here group in-
dustries into 17 categories as shown in Table 2. Simu-
lation was carried out for the individual regions re-
spectively.
The model has equations in linear form, with the
variables expressed in terms of the rate of change.
Thus the rate of change of demand for nominal house-
hold consumption (w3tot) is expressed in the model
as the sum of the rate of change of nominal GDP
(w0dgpexp) and a variable that denotes a shift in the
share of household spending (f3tot) in nominal GDP:
w3tot = w0gdpexp + f3tot (2-1)
Assuming that f3tot = 0, then w3tot = w0dgpexp,
thus the growth rates of nominal household consump-
tion and nominal GDP coincide, and the consump-
tion ratio (the average propensity to consume) remains
unchanged8. An exogenous shock to f3tot may change
the consumption ratio. It is assumed that the rate of

6 Ito et al. (2000).

7 JBIC has employed the GTAP (Global Trade Analysis Project) Model since 1997. The GTAP Model is an applied general
equilibrium model developed with the aim of analyzing the effect of global trade on individual countries across the world. It is based on
an international input-output table comprising 45 countries/regions and 50 industries (Database Version 4). For further details, see
Hertel (1997). The ORANI-G Model used here was developed jointly by the Australian government, Monash University, La Trobe
University and Australia National University under the Impact Project. The original ORANI Model, which became the basis for the
GTAP Model, was an applied general equilibrium model and divided the Australian economy into 56 regions and 112 industries. It has
been used to evaluate the effect of a change in taxation, reduction in tariffs, relaxation of the regulations, and environmental regulations.
The ORANI-G Model generalized this model by eliminating intra-country regional divisions of the ORANI Model to focus on the
specific conditions of individual countries. Though there is a major difference between the GTAP Model and ORANI-G Model in that
the former is a global model while the latter is a single-region model, they use the common software and share basically a similar
structure, with a few exceptions such as a more simplified consumption function used by the latter.
8 Strictly speaking, since the growth rates of the government and household spending coincide in terms of quantity rather than
value, the consumption ratio, which is the sum of spending in both the government and household sectors, is influenced by a change in
their relative price. The analysis here abstracted from this effect.
 JBIC Review No.4 99

Table 2 Industrial categories in model simulations

Aggregation Code Industry/Commodity

Agriculture AGR Agriculture, Forestry, Fishing
Mining MNG Coal, Petroleum, Gas, Other mining
Processed Food PFD Food, Beverages, Tabacco
Textile TXL Textile, Wearing apparel
Petroleum P_C Petroleum, coal products
Chemical CRP Chemical, rubber, plastic products
Metal MTL Ferrous metals
Motor Vehicle MVH Motor vehicles and parts
Other Transport Equipment TRN Other transport equipment
Electric Machinery ELE Electronic equipment
Other Manufacturing OME Other machinery and equipment
Other Manufacturing OMF Products of Leather, Wood, Paper, Mineral, etc.
Electricity EGW Electricity, Gas distribution, Water
Construction CNS Construction
Trade & Transport T_T Trade, Transport
Private Service OSP Financial, business, recreational service
Public Service OSG Public administration, education, health

change of real government spending ( x5 (c,s) ) is
equivalent to that of real consumption expenditure
(x3tot):
x5(c,s) = x3tot (2-2)
The value of f3tot that raises the consumption
ratio by 1 percentage point becomes:
f3tot = 1% × (Nominal GDP/Total nominal
consumption) (2-3)
Accordingly, the value of f3tot that increases the
consumption ratio by 1 percentage point was calcu-
lated for each region, using the database: 1.55 % in
Korea, 1.43 % in Taiwan, 1.79 % in Malaysia and
1.56 % in Thailand.
To solve the model, it is necessary to divide the
variables into endogenous and exogenous variables.
In this simulation, the model was closed by assuming
that induced investment increases capital stock and
leads to increased production, incorporating capital
accumulation effect. The current account balance will
vary endogenously, allowing international capital
movements. The country’s total labor input is fixed,
which makes wages an endogenous variable. Import
prices are assumed unchanged.
The process in which a given exogenous impact
will spread through the macroeconomy is as follows
(see Table 3). First, the average propensity to con-
sume increases, which raises both household and gov-
ernment consumption by 2.1 to 2.4 %. An increase
in consumption leads to more production, hence
higher demand for factors of production. While la-
bor input is fixed exogenously and thus unchanged,
capital input rises by 0.6 to 0.9 %. Wages also rise by
0.9 to 2.0 %, and the rental price of capital by 0.2 to
1.0 %. So do the prices of domestic products. Since
the prices of foreign products are fixed exogenously,
increased prices of domestic products affect trade,
reducing exports by 0.5 to 2.5 %, and increasing im-
ports by 0.8 to 1.7 %. In a closed economy, a rise in
the consumption ratio (lower saving ratio) will be
directly translated into a decline in the investment ratio
(since S = I). However, because the current account
balance changes endogenously, there will be capital
inflows from overseas and the increase of consump-
tion ratio does not necessarily cause a decline of in-
vestment ratio. Eventually, investment will rise by
0.6 to 0.9 %, thus leading to increased capital input.
The effect will be a 0.4 to 0.7 % increase in real GDP.
100

Table 3 Macroeconomic effects by increase of consumption ratio

(%)
Korea Taiwan Malaysia Thailand
(Change of quantity)
GDP 0.4 0.4 0.4 0.7
 Household consumption 2.2 2.1 2.3 2.4
 Capital formation 0.8 0.9 0.6 0.8
 Government consumption 2.2 2.1 2.3 2.4
 Export −2.5 −1.8 −0.5 −0.9
 Import 1.4 1.0 0.8 1.7
(Change of price)
GDP 1.5 0.9 0.4 0.5
 Household consumption 1.3 0.7 0.2 0.3
 Capital formation 0.9 0.5 0.2 0.2
 Government consumption 1.5 1.0 0.3 0.7
 Export 1.0 0.7 0.2 0.4
 Import 0.0 0.0 0.0 0.0
Change of current account/GDP −1.0 −1.0 −1.0 −1.0
Labor input 0.0 0.0 0.0 0.0
Capital input 0.9 0.9 0.6 0.8
Wage 2.0 1.3 0.9 1.3
Rental price 0.9 0.5 0.2 0.2

Note: Results of model simulation. The effect of one percentage point increase in the ratio of
consumption expenditure to GDP.

Since an exogenous shock of one percentage point
increase was given to the propensity to consume for
all the countries examined, its impact spreads through
each macroeconomy in the same process but in some-
what different degrees, depending on individual coun-
tries.
In Korea and Taiwan from the second half of the
1980s through the pre-crisis year, the saving ratio and
the investment ratio did not move in a parallel fash-
ion. In Korea, whereas the saving ratio reached a
peak of 39.7 % in 1988, and then falling to 33.7 % in
1996, the investment ratio in the same period soared
from 31.3 % to 38.4 %. Similarly in Taiwan, although
the saving rate hit 37.9 % in 1987, then plunging to
26.6 % in 1996, the investment ratio rose from 20.6
% to 23.2 % (after reaching a record 26.2 % in 1993).
The disparity between the saving rate and the invest-
ment ratio during this period was financed by capital
inflows from overseas. In analyzing East Asian
economies during this period, the assumption of en-
dogenous current account balance, or the existence
of capital movements, is consistent with actual de-
velopments and is therefore justified.
Our attention should focus not only on macro-
economic development but also on a shift in indus-
trial structure. As described above, since there was
an exogenous increase in the propensity to consume
in the simulation, this resulted in increased consump-
tion spending. In the model used here, the elasticity
parameter of household consumption expenditure is
set less than 1 for agricultural products and foods,
but larger than 1 for industrial goods and services.
This has resulted in disparate rates of growth in con-
sumption among different products. However, in most
products the resulting increases were generally 2 to 3
%. Also, the elasticity parameters for imports and
exports with respect to the relative price of domestic
and foreign goods are set for each industry in the
model. Therefore, any change in domestic prices will
affect import and export volume. According to the
 JBIC Review No.4 101

Table 4 Effects to industrial output by increase of consumption ratio

(%)
Agriculture Mining Manufacturing Electricity Construction Services
Korea 0.2 −0.7 −0.7 0.3 0.8 1.1
Taiwan 0.0 −0.6 −1.0 0.3 0.9 1.1
Malaysia 0.0 0.0 −0.1 0.6 0.6 0.9
Thailand 0.0 0.0 0.2 0.9 0.8 1.1
Note: Results of model simulation. The effect of one percentage point increase in the ratio of
consumption expenditure to GDP. Changes in production were tabulated by regrouping the
industries into six categories. The service sector includes commerce and transportation
(T_T), services in the private sector (OSP), and public service (OSG). The manufacturing
sector includes Processed food (PFD), Textile (TXL), Petroleum (P_C), Chemical (CRP),
Metal (MTL), Motor vehicle (MVH), Other transport equipment (TRN), Electric machinery
(ELE), Other machinery (OME) and Other manufacturing (OMF).

simulation, since upward pressure on domestic prices
occurred by an increase in consumption demand, ex-
ports fell and imports rose. However, the structure of
goods and services differs from one demand category
of to another. Whereas services make up a larger
portion of consumption demand, industrial and agri-
cultural products comprise most of the traded goods.
As a result, it was shown that when consumption and
imports increase, and exports decline, output in the
service sector will rise, but the manufacturing will
fall, and the share of the service sector in the economy
will increase.
The extent of a shift in industrial structure dif-
fered from one country to another. There was no sig-
nificant difference in the growth of service sector
output: 1.1 % in Korea, Taiwan and Thailand, and
0.9 % in Malaysia. The output in the manufacturing
sector, however, fell by 0.7 % and 1.0 % in Korea
and Taiwan respectively, but a decline was 0.1 % in
Malaysia, and in Thailand it rose by 0.2 %. Thus the
expansion of the service sector corresponding to a
change in propensity to consume proceeded more rap-
idly in NIES.
Why did the manufacturing output decline more
in NIES than in ASEAN countries? The first and fore-
most factor that may be considered is different de-
grees of price changes. ASEAN countries turn to
imports, whose prices do not change, for a large share
of their intermediate goods. Thus increased prices of
domestic factors of production are largely offset by
this factor, leading to a smaller increase in the price
of products (in particular traded goods) and thus a
smaller decline in exports. Further, another route may
be considered: the resulting more substantial struc-
tural change among NIES increased the prices of fac-
tors of production in these countries. Second, there
is a difference in the degree of depth in production
structure. ASEAN countries have a larger share of
assembly-and-processing-type manufacturing, with a
smaller share of domestic products being used as in-
termediate inputs. This means a smaller production
inducing effect in ASEAN countries. When final
demand decreases, there is a relatively small decline
in production. Third, the service sector has already
expanded its share to a certain extent in NIES, and
even if it grows at the same rate as elsewhere, the
effect on other industries is larger because of its large
share in the economy.
(3) Is growth based on export-led industrialization
sustainable?
If there were no constraints on factor inputs, in-
dustrialization responding to growing export demand
could leads to economic expansion. However, there
do exist constraints in factor inputs (in particular la-
bor input). Since workers are still moving from agri-
culture to the manufacturing sector, ASEAN econo-
mies are not considered short of labor. NIES, on the
other hand, have already got themselves out of the
state of labor surplus, and thus the manufacturing sec-
tor alone cannot enjoy growth without a change in
productivity in industries. They cannot solely focus
102

Table 5 Contributions of economic growth in Korea and Taiwan

(%)
Before the second half of the 1980's After the second half of the 1980's
Real Growth Labor Capital TFP Real Growth Labor Capital TFP
Total 9.3 1.9 2.7 4.8 7.5 1.8 3.4 2.3
 Agriculture 4.7 −2.5 1.7 5.5 0.8 −3.2 2.7 1.3
Korea

 Industry 11.9 3.5 3.2 5.1 8.3 1.2 3.5 3.6

  Manufacturing 13.4 4.1 3.4 5.9 7.7 0.0 3.7 4.0
 Services 8.6 3.5 3.0 2.1 8.1 3.9 3.6 0.5
Total 7.5 2.0 2.2 3.3 7.3 1.1 2.7 3.5
 Agriculture 1.3 0.4 0.4 0.5 1.0 −2.5 1.1 2.3
Taiwan

 Industry 7.7 1.7 2.0 4.0 5.3 0.4 2.0 2.9

  Manufacturing 8.9 2.4 2.0 4.5 4.9 −0.6 2.3 3.1
 Services 8.1 3.0 2.6 2.5 9.3 2.8 3.3 3.2

Note: Estimated from National Accounts Statistics, UN; Labor Statistics Yearbook, ILO; Taiwan Statistical Data Book, Council
for Economic Planning and Development. Figures before the second half of the 1980s indicate the average over 1980-88 in
Korea and 1980-86 in Taiwan. Figures after the second half of the 1980s indicate the average over 1988-96 in Korea and
1986-96 in Taiwan. The underlying equation9 is: y(t) = αk(t) + (1+α)l(t) + tfp(t), where α = 0.3

on export-led industrialization now, and must pay
sufficient attention to developments in the non-manu-
facturing industries. To put it the other way round,
the improvement in productivity is indispensable for
NIES if they are to continue export-led industrializa-
tion,.
How have NIES dealt with this situation since
the second half of the 1980s? Table 5 shows the break-
down of growth in Korea and Taiwan into contribu-
tions of capital, labor, and total factor productivity
(TFP) before and after the time when industrializa-
tion reached its peak (1988 in Korea and 1986 in Tai-
wan). Note that this table simply uses the number of
employees as labor input and does not take into ac-
count changes in the quality of workers and working
hours. These factors are included in the TFP. In both
Korea and Taiwan, output growth in the manufactur-
ing sector significantly slowed down. In Korea, 4.1
% out of the 5.7 % decline in growth rate of the over-
all economy was attributable to a fall in contribution
of labor input. In Taiwan, the comparable figure was
3.0 % out of 4.0 %.
If they cannot turn to labor input for economic
growth, they have no choice but to rely on increases
in capital input and TFP. Even if the propensity to
consume rises, brisk investment demand may be fi-
nanced by increased capital inflow. Investment ac-
tivity was brisk in Korea and Taiwan, as attested by
the increased contribution of capital input even after
the second half of the 1980s. The pattern of interna-
tional capital movement was that Korea had larger
capital inflows and Taiwan observed smaller net capi-
tal outflows.
TFP still accounted for a majority of growth in
the manufacturing sector, although its contribution
decreased. In comparison with the overall industries,
TFP in the manufacturing sector grew almost at the
same rate in Taiwan. By contrast, in Korea the manu-
facturing sector far exceeded the overall industries in
terms of TFP growth. In other words, productivity
improved not only in the manufacturing sector but in
the other sectors as well in Taiwan, while TPF grew
mainly in the manufacturing sector in Korea and
hardly did so in the service sector.

9 Capital stock was estimated in a simple procedure from fixed capital formation with the following equation. Capital stock at
current period t is equal to current investment plus capital stock in the previous period minus depreciation; k(t) = I (t) + (1-δ)k(t-1) .
Capital stock is assumed to depreciate at δ = 0.1.
 JBIC Review No.4 103

Table 6 Contributions of added value growth in Korean manufacturing industries

(%)
1980∼88 1988∼96
Total Labor Capital TFP Total Labor Capital TFP
Total Manufacturing 11.5 3.8 3.0 4.7 10.4 −0.9 4.0 7.2
Food products 6.3 1.7 2.5 2.2 7.1 −0.9 3.0 5.0
Textile & Apparel 8.2 1.8 1.7 4.7 3.9 −3.8 2.0 5.8
Wood products 9.9 1.7 0.6 7.7 11.8 −0.1 5.9 6.0
Paper products 11.6 3.2 3.6 4.8 11.8 1.4 4.1 6.3
Chemical products 8.7 2.1 2.7 3.9 8.5 0.3 4.6 3.6
Petroleum & Coal 5.6 0.5 2.3 2.8 9.6 −1.0 6.3 4.2
Rubber, Plastic products 13.1 5.5 4.0 3.6 10.1 −4.5 4.8 9.8
Mineral products 7.6 2.0 2.4 3.2 10.9 0.1 4.0 6.7
Iron & steel, Other metal 10.5 2.4 2.6 5.5 8.5 −0.1 2.8 5.8
Metal products 17.5 6.3 3.8 7.4 13.0 1.7 4.2 7.1
Electric machinery 20.6 7.2 5.6 7.8 13.7 −0.8 4.7 9.7
Transport equipment 16.0 5.5 4.1 6.4 15.6 2.6 5.0 7.9
Other machinery 20.3 7.8 3.5 9.1 15.4 4.2 4.8 6.4
Note: Estimated from Industrial Statistics Database, UNIDO in the same manner as in Table 5.

The simulation above showed that, if we ignore
improvement in TFP, an increase in consumption
pushes up the wage level and prices in NIES more
than in ASEAN countries because of difference in
economic structure. The larger increase in prices there
depresses exports, impeding GDP growth. However,
to the extent TFP improves, prices will rise less, hence
a smaller reduction in exports, contributing more to
GDP growth. The share in value added of Korea’s
manufacturing sector in current prices has declined
since 1988. On the other hand, in Table 5, which
used figures in constant prices, shows a small increase
in the share of the manufacturing sector, whose growth
in terms of value added slightly surpassed that of the
overall industry. The divergence of the nominal and
real figures signifies a decline in prices of manufac-
turing relative to those of other sectors because of
improved TFP in the manufacturing sector. One may
easily understand that an increase in TFP is essential
for achieving a robust export-led growth.
Since the manufacturing sector includes various
industries, it is better to look into specific industries.
Table 6 shows growth accounting corresponding to a
breakdown of the Korean manufacturing sector by
industry. The contribution of factors of production
to growth in industry’s value-added was calculated
in the same manner as in Table 5.
It should be kept in mind that since the UNIDO’s
data cover only those firms with 5 or more employ-
ees, micro firms with 4 or fewer employees are ex-
cluded in Table 6, whereas the data used for Table 5
include them. Apart from those micro firms, contri-
bution by labor input decreased in Korea, as was the
case in Table 5, but the contribution of capital input
as well as TFP increased. As a result, the growth rate
of output in value added terms remained high. Thus
when comparison is made of the figures for the total
manufacturing sector in the two tables, we see that
the disparities among firms widened, as large com-
panies were more active in investments. By industry,
we found that all the industries grew by increasing
employment and investment before 1988, but after
1988 light industries such as textiles reduced employ-
ment, while the heavy industries such as general ma-
chinery and transportation equipment continued to
hire more employment. Structural change was un-
derway in the manufacturing sector, which was a mix-
ture of the industries growing through capital substi-
tuting for other factors and those expanding by sim-
ply increasing both factor inputs.
Korea relied on the growth of the export-oriented
manufacturing sector well after the arrival of post-
104
industrial period since the mid-1980s. Unable to in-
crease labor input, the manufacturing sector tried to
improve productivity through active capital invest-
ment and expansion of operation for the scale
economy. Meanwhile, TFP in the non-manufactur-
ing sector did not rise, giving rise to the high cost
structure. In order to increase exports, the manufac-
turing sector had to further increase productivity and
produce higher value-added products. However, this
approach involved two risks. First, if a product of a
certain industry is in short supply, that industry would
enjoy benefits from scale expansion. On the other
hand, once excess supply occurs, the market price will
plummet and productivity growth will come to a halt.
Second, growth relying on investment will inevita-
bly lead to greater capital inflows from overseas when
the ratio of domestic consumption to total income in-
creases and the saving rate decreases. One of the fac-
tors that brought about the currency crisis was exces-
sive dependence on short-term financing for invest-
ment under such circumstances.
CHAPTER 2 IMPACT OF
CURRENCY DEPRECIATION
1. THE ASIAN CURRENCY CRISIS
A huge amount of capital continued to flow in the
crisis countries in the pre-crisis period. Those econo-
mies had enjoyed a sustained high economic growth
right up to the crisis, indicating an investment boom.
Financial liberalization and globalization also pro-
gressed quickly during this period, inducing invest-
ment inflows from overseas and expanding current
account deficits. Foreign investors could expect high
returns on their investments due to strong economic
growth, and were able to avoid exchange risk be-
cause of the government policy to fix the domestic
currency to the US dollar. Reassured by good mac-
roeconomic performance, and in particular, the
sound fiscal position, the investors were not alarmed
by the ballooning current account deficit.
A long period of investment boom and high eco-
nomic growth, however, led to soaring wages and
declining profitability of investment. In addition,
since the real exchange rate appreciated under the
policy of fixing nominal exchange rate, and due partly
to depreciation of the yen since 1996, their competi-
tive edge deteriorated, and export growth lost its
steam. As for capital inflows, which initially com-
prised mainly direct investment, the share of short-
term capital including bank loans rapidly increased
in a couple of years preceding the crisis. Surplus in-
vestment funds moved into the real estate and con-
struction sector and caused the asset bubble in Thai-
land, while in Korea the investment boom did not
wind down and demand was financed by roll-over of
the short-term loans, thus further fueling liquidity
mismatch.
It was under these circumstances that the cur-
rency crisis erupted in Thailand. What actually trig-
gered the crisis was allegedly the selling offensive of
the Thai baht by hedge funds in May 1997, after the
asset bubble collapsed and bad loans had accumu-
lated in the financial sector. The Thai monetary au-
thority tried to resist these funds by buying the baht,
only to find itself running out of foreign currency re-
serves. With their confidence in the fixed rate policy
shaken, foreign investors also withdrew their short-
term capital in panic, and the Thai government had
no choice but to abandon the fixed exchange rate
policy. In Korea, there was no real estate bubble, but
corporate behavior put weight not on profitability but
on gaining greater market share, and the financial
system had been extremely inefficient. Korean banks
had also borrowed short-term loans in foreign cur-
rencies from foreign financial institutions. Because
of the increasing burden of non-performing loans, they
found it hard to refinance the short-term capital that
would fall concurrently due in December 1997, thus
exposing the crisis to public attention. In Indonesia,
the crisis worsened, fueled by political unrest. And
the crisis also spread to Malaysia and the Philippines.
2. MODEL SIMULATION
(1) Framework of model simulation
The fixed exchange rate system allows foreign
investors and firms to undertake investment and
trade without concerns over the risk of exchange rate
fluctuations. But it has its shortcomings. Adjust-
ment of the real exchange rate takes an overly long
time, overvaluing the currency, and thus weakening
 JBIC Review No.4 105

competitiveness; and the authorities lose a free hand
in conducting monetary policy. If the fixed-rate sys-
tem is to be maintained upon eruption of capital out-
flow, the authorities have no alternative but to use the
foreign currency reserves or raise interest rates. In
the crisis countries, the authorities could not imme-
diately devalue the exchange rate, because the com-
panies and banks in the country, oblivious of exchange
risk, relied on loans in dollars, and there is risk that
they would turn into bad loans. After the crisis, how-
ever, a massive amount of foreign capital switched to
outflows, consequently forcing them to leave the fixed
exchange rate regime. As a result, their currencies
lost much of their value. Having borrowed in dollars
without hedging against exchange risks, increasing
numbers of companies found their loans rapidly be-
coming delinquent as the currency depreciated, fur-
ther deteriorating the situation. Further, the decline
of exchange rates exerted a serious impact on trade
and industrial structures in each country, through
changes in export and import prices.
This paper examined the impact of changes of
the exchange rate on the individual economies with
an applied general equilibrium model. The GTAP
Model cannot make this type of analysis because the
nominal exchange rate is not defined in the model.
With the ORANI-G Model, however, the nominal
exchange rate is defined, enabling us to analyze
changes in the exchange rate. That is the reason this
paper has selected this modeling framework.
The exchange rates against the US dollar plunged
sharply across the countries after the Asian crisis. The
post-crisis rates were: nearly two-thirds of the pre-
crisis level in Korea, Malaysia, Thailand and the Phil-
ippines, and one-third in Indonesia. In the simula-
tion, the effect of a 33% exchange rate depreciation
was examined with respect to Korea, Thailand and
Malaysia-the three economies that suffered the simi-
lar plunge. In the Model, import prices in the foreign
currency are exogenously fixed. Assuming that the
exchange rates pass through by 100 %, import prices
in the local currency increase by 33 %. The change
in export prices in the foreign currency is the sum of
changes in the price of domestic products and the
change in the exchange rate 33 % depreciation.
In the model closure, it was decided not to in-
clude the effect of capital accumulation in which a
change in investment flow will lead to an increase in
production through a change in capital stock. In other
words, this analysis focuses on a short-term impact
by considering investment solely as a demand com-
ponent, keeping unchanged total capital stock that
determines supply capacity.10 With regard to labor
market, wages are assumed to be exogenous, and la-
bor input endogenous.11 In other words, we assume a
situation where employment fluctuates under a given
wage increase rate. This wage increase rate is as-
sumed to be linked to the rate of increase in consumer
price index, which is fixed at 10 % for the three coun-
tries on the basis of the rate of price increase in the
1997-1998 period.12 The saving rate is fixed, while
the current account is an endogenous variable, thereby
allowing international capital movements to occur.
The simulation considers three scenarios. In the
“Standard Case”, the return on capital is determined
endogenously, and standard figures from the database
are used for the substitution elasticities of imports.
But since the Asian crisis brought about a shortage in
foreign exchange reserves, in addition to an increase
in import prices, creating constraints on importing raw
materials, simulation was made for the “Case of Im-
port Constraint” where the elasticity of substitution
between domestic goods and imported goods was set
at double the Standard Case. Further, there may have
been a sharp drop in return on investment due to the
impact of the burst of the economic bubble and

10 The short-term impact in this section does not include stock accumulation effect, and this simulation is not a reproduction of a
deflationary effect immediately following the crisis.
11 In this simulation, the exogenous shock is a change in the exchange rate. Therefore, if the wage level becomes endogenous, only
the price level would change (real exchange rate fluctuation would be zero), and quantity variables would remain unchanged. This
assumption is necessary in order to create a situation where the real exchange rate depreciation leads to changes in quantity varialbes.
Also, there will be no impact on quantities if the domestic prices rise, so it would be more suitable to limit the simulation to the short-
term rather than the long-term analysis that includes the capital accumulation effect.
12 An analysis on Indonesia was not conducted mainly because the currency depreciated against the US dollar by around 65%, but
the rate of price increase exceeded 80% for the two year period of 1998-99, with no depreciation in the real exchange rate.
106

Table 7 Impact of Exchange Rate Depreciation on Asian Economies

(%)
Standard case Case of import constraint Case of lower return on capital
Korea Malaysia Thailand Korea Malaysia Thailand Korea Malaysia Thailand
(Change of quantity)
GDP 4.6 5.6 3.8 3.8 5.0 3.4 −1.4 1.0 −0.6
Household consumption 1.1 2.6 1.5 0.4 2.0 1.1 −5.0 −3.3 −4.6
Capital formation −18.3 −4.1 −9.5 −29.7 −15.5 −17.3 −54.6 −67.6 −57.9
Government consumption 1.1 2.6 1.5 0.4 2.0 1.1 −5.0 −3.3 −4.6
Export 26.0 8.0 9.9 26.5 8.3 9.9 37.4 14.6 22.9
Import −6.0 2.0 −5.2 −16.7 −2.3 −11.5 −27.8 −16.4 −34.3
(Change of price)
GDP 18.2 26.2 26.4 18.3 26.0 26.4 13.8 22.0 20.6
Household consumption 22.2 29.9 29.3 22.4 29.8 29.2 18.2 27.5 25.6
Capital formation 22.3 29.7 30.0 22.1 29.6 30.0 19.0 28.0 26.5
Government consumption 16.1 25.4 21.1 15.9 25.4 21.1 14.1 24.5 18.3
Export 22.4 29.2 27.9 22.2 29.1 27.9 18.6 26.3 22.3
Import 33.0 33.0 33.0 33.0 33.0 33.0 33.0 33.0 33.0
Change of current account/GDP 7.6 2.7 5.0 11.7 6.5 8.3 19.5 23.8 24.5
Labor input 10.8 18.3 18.4 10.0 17.5 18.4 −0.3 5.6 8.6
Capital input 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Wage 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0
Rental price 22.3 29.7 30.0 22.1 29.6 30.0 12.9 21.5 20.0
Note: Results of model simulation. The effect of exchange rate depreciation by 33%.

overinvestment. Thus simulation was also made for
the “Case of Lower Return on Capital,” assuming that
in addition to import constraints, the rate of return on
capital declines by 10 percentage points.
(2) Standard Case
The effect of depreciation in the exchange rate
will generally spread in the following manner. First,
export volume will increase due to lower dollar prices
of exports. The import volume will decrease due to
higher prices of imports in local currency. As a result
of current account surplus and the outflow of capital,
domestic investment will slow down.13 Since the rise
in external demand exceeds the drop in domestic de-
mand, real GDP will nonetheless increase.
However, the extent of change varies from coun-
try to country. In the standard case, the increase in
export volume is a significant 26.0% in Korea, but
8.0% and 9.9% for Malaysia and Thailand respec-
tively. This difference is mainly attributable to a
smaller increase in the price of export goods in Ko-
rea compared with Malaysia and Thailand. The rea-
son for this lower price hike is the higher percentage
of imported materials used in the production of ex-
port goods in Malaysia and Thailand. Another rea-
son is, due to the closure of the simulation, namely
the constraint that the amount of total capital is as-
sumed unchanged, the price of capital will increase
by a wide margin in Malaysia and Thailand, econo-
mies short of capital. Also, a 33% rise in import prices
will theoretically result in lower import volume. The
result is that while the volume declines in Korea and
Thailand, it increases by 2.0 % in Malaysia. This
result is obtained uniquely by the applied general

13 This simulation examines short-term effects. Thus capital stock is fixed. This may generate a situation where the concentration
of domestic resources will shift from investment goods production sectors to export goods production sectors, leading to a fall in
investment. Although investment demand induced by the increase in export demand is considered to be a long-term phenomenon, this
factor is not reflected in this simulation.

equilibrium model. The reason for the increase in
import volume despite the sharp rise in import prices
is because the production structure for export goods
in Malaysia is largely dependent on imported inter-
mediate materials. In such a structure, the import
volume of intermediate materials must be increased
in order to increase the production of export goods.
Turning to the current account, a significant sur-
plus occurs in Korea where export volume increases
and import volume falls. But in Malaysia, an increase
in surplus is minimal because export volume in-
creases, while import volume decreases slightly.
Thailand represents an intermediate case between the
two countries. Because an increase in current account
surplus indicates corresponding capital outflow, the
impact on domestic investment is a large18.3 % de-
cline in Korea and a relatively minor 4.1 % fall in
Malaysia.
With regard to the impact on real GDP, Malaysia
had the highest 5.6 % as a decline in investment is
modest in spite of a small rate of increase in external
demand. In Korea, the impact is smaller 4.6 % be-
cause a significant boost in external demand accom-
panies a large fall in investment. The impact is the
smallest 3.8 % in Thailand among the three countries.
(3) Case of Import Constraint
In this model, intermediate goods, investment
goods and consumption goods respectively consist
of domestic goods and imported goods, which are
assumed to be incomplete substitutes, following
Armington assumption. Their proportions are deter-
mined by CES production functions.
Take intermediate inputs as an example. Let
SIGMA1(c) be the value of Armington elasticity be-
tween domestic goods and import goods, the relation-
ship between quantities demanded for domestic goods
and import goods as x1(c,s,i). Then the combined
demand ( x1_s(c,i) ) will be expressed as equation
3-1, where p1(c,s,i) is the respective prices of domestic
goods and import goods, and p1_s(c,i) is the com-
14 Among NIES and ASEAN countries, there are cases where domestic substitutes for import goods are not produced. Under such
circumstances, production activities will halt if parts cannot be imported. In fact, there were many companies that suspended operations
in the wake of the crisis because they could not procure imported intermediate goods. Such a strict condition is not applied in this
simulation due to the technical restriction of the model.
JBIC Review No.4 107
bined price.
x1(c,s,i) = x1_s(c,i)
- SIGMA1(c) * [p1(c,s,i) - p1_s(c,i)]
(3-1)
In other words, the rates of change of demand
for domestic and import goods are obtained as fol-
lows. The rate of change of the combined demand
minus the difference between the prices of domestic
and import goods and the combined price multiplied
by the Armington elasticity. This is also true for in-
vestment goods and consumption goods.
In this case, the Armington elasticities between
domestic and import goods for intermediate goods,
investment goods, and consumption goods were set
twice the standard values. Since the prices of import
goods rise due to exchange rate depreciation, demand
for domestic goods will increase and import goods
decrease. But by doubling the value of substitution
between imports and domestic goods, adverse effect
on imports is exaggerated.14
The economic impact in this case is basically
similar to that of the standard case, but substitution
by domestic products was more pronounced due to
import difficulties, and thus the decrease in imports
was greater than in the standard case. Even in Ma-
laysia, which showed a 2.0 % increase in the stan-
dard case, imports fell by 2.3 %. Since there was less
reliance on import goods whose price increased
sharply, production prices for export goods edged
lower in Korea and Malaysia. This resulted in a larger
increase in export compared with the standard case.
In comparison with the standard case, the rate of
decrease of import goods was larger so that the ratio
of current account surplus to GDP rose by around 4
%. Therefore, external demand made higher contri-
bution to economic growth. Capital outflow will also
increase to the extent that the current account surplus
increases. This will have a stronger impact on in-
vestment, as the magnitude of decrease widens.
Therefore, whereas external demand makes a sig-
108
nificant contribution, the decline in investment and
other domestic demand component is greater, and thus
the overall impact on real GDP is 0.4-0.8 % smaller
than the standard case.
(4) Case of Lower Return on Capital
In this model, the following equation sums up
the relation between the rate of change of current re-
turn on capital (r1cap(i)), the rate of change of the
rental price of capital (p1cap(i)), and the rate of change
of the price of investment goods (p2tot(i)).
r1cap(i) = 2.0 * (p1cap(i) - p2tot(i)) (3 - 2)
In other words, the rate of change of current re-
turn on capital is two times the difference between
the rate of change of the price of investment goods
and the rate of change of the rental price of capital,
i.e., the rate of change of gross return on investment.
The multiplier 2.0 represents the ratio of gross profit
to net profit (gross profit minus depreciation).
Assume that the rate of change of fixed capital
formation for industry i is x2tot(i), the rate of change
of its capital stock x1cap(i), and global return on capi-
tal omega. Then, investment behavior of the indus-
try is expressed by,
x2tot(i) - x1cap(i)
= 0.33 * [r1cap(i) - omega] (3 - 3)
This equation indicates that investment is allo-
cated according to relative change in profitability in
specific industry, multiplied by an elasticity of 0.33.15
In the case of lower return on capital, in addi-
tion to the assumptions made in the previous case,
the current return on capital, or r1cap(i), is assumed
to decrease by 10 % across all industries. The simu-
lation results shows that the rise in capital rental price
is around 10 % points lower than the standard case
and import restraint case, thereby curbing an increase
in general domestic prices.
With regard to the impact on trade, more re-
strained upward pressure on domestic production cost
of export goods will lead to an increase in export vol-
15 The equation, Saving-Investment Differential = Current Account Surplus, is used to calculate the total amount of fixed capital
formation in one country.
ume by 37.4 % in Korea, 14.6 % in Malaysia, and
22.9 % in Thailand. On the other hand, because the
relative price differential between domestic and im-
port products increases, import volume will decrease
by 27.8 % in Korea, 16.4 % in Malaysia and 34.3 %
in Thailand. As a result, the ratio of current account
to GDP will change, generating a significant surplus
of 19.5 % in Korea, 23.8 % in Malaysia, and 24.5 %
in Thailand.
In the case of lower return on capital, the rise in
prices is not just lower than in the standard case. But
income generated from capital has to decrease rela-
tive to the two previous cases to the extent that the
rental price of capital decreases (the rise in rental price
of capital is curbed). For this reason, not only the
allocation on investment decreases sharply but con-
sumption will also decrease due to a fall in income,
resulting in a large decline in domestic demand. Real
GDP increases by 1.0 % in Malaysia. But it decreases
by 1.4 % in Korea and 0.6 % in Thailand because
negative contribution by domestic demand exceeds
positive contribution by external demand.
(5) Effects on Industries
Exchange rate depreciation, results in an increase
in export volume due to lower export prices, and a
decrease in import volume due to higher import prices.
Because of capital outflow and concentration of re-
sources in the production of export goods, investment
activities will mark a sizeable fall.
While such is the macroeconomic effect, the
impact of depreciation varies by industry because the
input-output and the trade structure differ for each
industry (Table 8).
First, the impact will vary, depending on whether
the industry’s production is oriented toward domes-
tic or external demand. The higher the weight on
external demand, the higher the rate of increase of
production. However, changes in export volume
heavily depend on changes in the cost of its domestic
production. The change in production cost is deeply
associated with the input structure. And since the in-
 JBIC Review No.4 109

Table 8 Changes in Output due to Exchange Rate Depreciation

in External & Domestic Market-Oriented Industries
(%)
Standard case Case of import constraint Case of lower return on capital
External Domestic External Domestic External Domestic
Korea 3.2 2.8 3.6 2.3 3.7 −2.4
Malaysia 4.2 1.9 4.7 1.0 5.8 −4.8
Thailand 2.9 1.4 3.2 0.9 4.6 −3.8
Note: Results of model simulations. Impact of 33% currency depreciation. Figures for external
demand-oriented industry is a total for mining and manufacturing industries with over 25%
export ratio. Domestic demand-oriented industry is a total for all other industries. External
demand-oriented industry in Korea includes textiles/apparel, automobiles, other transport
equipment, electric machinery, and general machinery; in Malaysia, mining, food,
textiles/apparel, chemicals, metals, other transport equipment, electrical machinery, general
machinery, and other manufacturing industries, and in Thailand, mining, food, textiles/apparel,
chemicals, other transport equipment, electrical machinery, general machinery, and other
manufacturing industries.

crease rate of the price of imported intermediate goods
are greater than that of domestic intermediate goods,
the greater the proportion of imported intermediate
inputs, the higher its production cost, leading to a
smaller increase in export volume.
Even though import prices increase, import vol-
ume will not decrease for all products. The structure
of the model is such that if the relative price on im-
ports increase, then their shares in intermediate goods,
investment goods and consumption goods will de-
crease. However, If absolute quantities demanded for
these goods increase, the import volume of individual
goods will not necessarily decrease. Especially since
the production function has the Leontief-type fixed
input structure, demand for intermediate inputs will
also increase in industries where production increases
together with exports. Thus despite a fall in the share
of imports, it is not rare to see cases where import
volume increase. In Malaysia, as mentioned earlier,
the overall import volume increased under the stan-
dard case.
Since productive resources are concentrated on
the production of export products, investment activi-
ties will drop sharply across all industries. As a re-
sult, production will fall substantially in industries
whose output has a high share of investment goods.
(6) Rapid Recovery after the Crisis
The Asian economies made a significant turn-
around during the 1997-98 period, with the ratio of
current account balance to GDP shifting from -1.7 %
to 12.8 % in Korea, from -5.1 % to 13.0 % in Malay-
sia, and from -2.1 % to 12.7 % in Thailand. In 1998,
however, due to a major drop in domestic demand
including consumption and investment in the private
sector, the real economic growth rate posted -6.7 %
in Korea, -7.5 % in Malaysia, and -10.2 % in Thai-
land. Then again, entering 1999, the real growth rate
showed a steep gain against the initial forecasts of
slow recovery, with 10.7 % in Korea, 5.4 % in Ma-
laysia and 10.2 % in Thailand. The major engine of
this strong growth was exports that showed a hefty
increase due to the depreciation of the local curren-
cies. It may be also attributable to a boost in exports
of electrical and electronic machinery supported by
the ongoing Information Technology (IT) revolution,
as well as expanding export demand driven by the
bustling US economy.
As the simulation showed, domestic demand
plunged at the time of the crisis, offsetting the benefits
brought about by the exchange rate depreciation. How-
ever, once the confusion subsides and production ac-
tivities are back on a normal track, the export-lead
growth materializes. Nonetheless, this recovery is
heavily leaning on the export sector; while the export-
oriented industry shows a robust growth, the domestic
market-oriented sector posts only a small increase.
Further, the effects of export expansion and currency
depreciation may be short-lived, since they are effec-
tive only when the real exchange rate depreciates, i.e.,
when the price level stays unchanged despite a fall in
the nominal exchange rate. However, they will be-
110

come ineffective once the real exchange rate gets back
to the former level due to price hikes.
CHAPTER 3 THE EFFECTS OF
DECLINING INVESTMENT/GDP RATIO
1. TRENDS IN INVESTMENT RATIO AND
SAVING RATIO AFTER THE ASIAN CRISIS
Capital stock accumulated during the high economic
growth period in East Asia, which increased the ca-
pacity of output, and there is no doubt that this trend
provided underpinnings for high economic growth in
the region.16
East Asia is unique for its high investment ratio
to GDP, and also for the high saving ratio that sup-
ports its investment (Table 9). The high saving ratio
can be attributed to 1) an increase in income result-
ing from rapid economic growth, and 2) inflation
reined in by macroeconomic economic stabilization
policies, which kept real interest rate positive, giving
an incentive to saving. In the area of financial sys-
tem, 1) efforts were made to ensure the stable bank-
ing system in order to keep depositors’ confidence in
the financial institutions, and 2) the postal savings
system was developed to accommodate small-sum de-
positors and rural depositors. The high investment
ratio can be attributed to the robust investment de-
mand generated by the stable macroeconomy and
rapid growth, and a strong drive by governments of
various policies to promote investment. For example,
the governments took to policy lending by establish-
ing financial institutions to provide financing to agri-
culture and small- and medium-sized enterprises, and
development banks to meet long-term financing
needs. They also adopted a tax policy to increase
corporate internal reserves and thus investment. And
by limiting the outflow of capital, the government
channeled domestic savings into investment, curbed
the interest rate on deposit and thus the lending rate.
Tariff and foreign exchange policies also kept down
the relative price of investment goods and capital
equipment, inducing investment activities.
After the Asian currency crisis, domestic demand

Table 9 Ratio of Investment & Savings to GDP Before & After the Asian Crisis
(%)
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Korea Saving Ratio 37.2 37.2 36.3 36.0 35.0 35.2 33.7 33.1 42.3 34.1 30.9 27.9
Investment Ratio 37.7 39.9 37.3 35.5 36.1 37.0 38.4 35.0 29.0 27.3 28.5 27.2
Difference -0.5 -2.7 -1.0 0.5 -1.1 -1.8 -4.7 -1.9 13.3 6.8 2.4 0.7
Indonesia Saving Ratio 32.3 33.5 35.3 32.5 32.2 28.5 27.3 29.9 19.1 18.5 15.2 18.0
Investment Ratio 30.7 32.0 32.4 29.5 31.1 31.9 30.7 31.3 18.0 17.5 13.0 17.5
Difference 1.6 1.5 2.9 3.0 1.1 -3.4 -3.4 -1.4 1.1 1.0 2.2 0.5
Philippines Saving Ratio 33.4 33.5 36.5 37.7 39.6 39.7 42.9 37.3 39.6 37.7 35.4 35.0
Investment Ratio 31.2 37.2 35.1 37.8 41.2 43.6 41.5 42.9 26.7 23.7 24.1 25.0
Difference 2.2 -3.7 1.4 -0.1 -1.6 -3.9 1.4 -5.6 12.9 14.0 11.3 10.0
Thailand Saving Ratio 34.3 36.1 36.0 34.9 34.6 33.4 33.6 32.4 39.3 36.4 36.3 36.0
Investment Ratio 41.4 42.8 40.0 39.9 40.2 41.4 41.7 33.2 26.1 26.8 30.4 33.0
Difference -7.1 -6.7 -4.0 -5.0 -5.6 -8.0 -8.1 -0.8 13.2 9.6 5.9 3.0

Sources: Figures through 1999 are from World Development Indicators, World Bank, figures for 2000 and 2001 are estimates
using Asian Development Outlook 2000, Asian Development Bank. The investment ratio is the ratio of domestic
fixed capital formation (gross domestic fixed capital formation in Indonesia) to GDP. The saving ratio is the ratio
of gross domestic savings (nominal GDP – total consumption expenditure) to GDP.

16 Economic Planning Agency (1999) said “There are different views on the extent of contribution that technical progress and
economic efficiency had on high economic growth in East Asia. However, the contribution ratio to total factor productivity averages
around 20 %, and it is agreed that increase of capital stock and labor had a significant contribution on economic growth.”
 JBIC Review No.4 111

Table 10 Capital Stock Growth Rate

(%)
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Korea 14.2 14.0 11.5 10.6 10.7 10.9 10.3 9.2 3.0 5.8 6.7 6.1
Indonesia 8.7 9.3 8.5 8.3 8.9 9.8 10.2 10.0 1.8 -0.9 -0.2 1.8
Malaysia 9.1 10.7 10.6 11.2 12.1 13.3 12.7 12.1 6.3 5.0 5.2 5.7
Thailand 13.2 13.1 12.1 11.6 11.6 11.6 10.7 6.9 2.9 3.2 4.4 5.2
Note: Estimated from World Development Indicators, World Bank and Asian Development Outlook 2000,
Asian Development Bank. Capital stock was estimated in the same way of the footnote No.9.

and, in particular, capital investment declined sharply.
If economic recovery triggers investment activities
to return to pre-crisis levels, then we can say that the
Asian currency crisis was just a temporary slump and
was not a threat to the potential growth of the Asian
economies. However, if investment sentiment were
slow to recover due to the collapse of the bubble
economy and delays in addressing non-performing
loans, then this would have a significant effect on the
Asian economies because they relied primarily on
capital accumulation, especially physical capital,
among other factors, for economic growth. If such is
the case, we cannot deny the possibility that they
might come closer to a situation where, like Japan
after the first oil crisis, there will be a slowdown in
high investment ratio of the rapid economic growth
period, moving the economy to the moderate growth
path.
When comparing the ratio of fixed capital for-
mation to GDP (investment ratio) between 1996 and
1998, namely before and after the crisis, it declined
about 9 to 15 percentage points in major Asian coun-
tries-from 38.4 to 29.0 % in Korea, from 41.5 to 26.7
% in Malaysia, from 41.7 to 26.1 % in Thailand, and
from 30.7 to 18.0 % in Indonesia. On the other hand,
when the ratio of savings (which is GDP minus con-
sumption) to GDP for the same period fell sharply in
Indonesia from 27.3 to 19.1 %, but increased from
33.7 to 42.3 % in Korea, and from 33.6 to 39.3 % in
Thailand. And a decline in Malaysia was small-from
42.9 to 39.6 %. Further, estimates based on figures
from the Asian Development Bank (2000) indicate
that the investment ratio that dropped sharply after
the Asian currency crisis is showing some resilience
from 2000 to 2001 in Thailand and Indonesia, but
figures for Korea and Malaysia remained low and
have yet to recover (Table 9).
The rate of growth of capital stock is shown in
Table 10. In the first half of the 1990s, annual aver-
age of capital stock growth rate remained high at
around 9 % in Indonesia and 11 to 12 % in Korea,
Malaysia and Thailand. But this rate has slowed down
as investment level dropped sharply after the Asian
currency crisis. Although the rate showed a moder-
ate increase in 1999 to 2001, it is still 0 to 2 % in
Indonesia, and 4 to 6 % in Korea, Malaysia and Thai-
land. Therefore, if the contribution of capital input is
calculated assuming that the ratio of added-value to
capital is one third, the contribution of capital stock
to growth will drop by 2 to 3 percentage points across
the countries-from around 4 % before the crisis to 1
to 2 % after the crisis in Korea, Malaysia and Thai-
land, and from around 3 % to between 0 and 1 % in
Indonesia.
However, the contribution of capital stock only
affects medium- to long-term potential growth. It
should be noted that if a wide gap between supply
and demand, changes in the capacity utilization and
durable periods of capital equipment are taken into
consideration, a slowdown in the growth rate of capi-
tal stock should not immediately lead to lower growth.
The Asian economies are said to have experienced a
large deflationary gap due to negative growth in 1998.
The effects of slowdown in the capital stock growth
would only surface after the deflationary gap were
narrowed. Since 1999, the economies have shown a
V-shaped recovery at a faster pace than expected, and
the current situation would not pose a problem if eco-
nomic growth leads to higher investment, as in the
pre-crisis period. However, if smooth progress is not
112
Figure 11 Evolution After the Asian Currency Crisis
Savings & Investment Ratio
Saving Ratio
Investment Ratio
made in structural reform and disposal of non-per-
forming loans, which would hamper investment, then
we may see some adverse effects in the future.
2. MODEL SIMULATION
This section analyzes the effects of a declining
investment ratio on the Asian economies. Three pat-
terns may be considered as shown in Figure 11, if we
draw on different experiences during the Asian cur-
rency crisis. Initial decline in the investment ratio is
common in all three patterns. In the first case, the
investment ratio declines but recovers shortly after-
wards (1 in Figure 11). This may be considered a
pattern associated with ordinary business cycles. In
the second case, the investment ratio drops, whereas
the saving ratio remains unchanged (2). Malaysia
and Thailand fit this pattern. In the third case, the
investment ratio drops and the saving ratio follows
suit (3). Indonesia falls on this pattern.
In the first case, however, analysis is difficult
because it is a static model where we can grasp the
change from one equilibrium point to another, but
cannot describe the process in between. Therefore,
this section will focus on the second and the third
case.
First, let us consider case 2 where the investment
ratio falls but the saving ratio remains unchanged.
Here a fall of the investment ratio by one percentage
point is considered. As seen in Chapter 2, in the
ORANI-G Model, the rate of change in nominal
household consumption demand is the sum of the rate
Time
of change in nominal GDP and a shift variable with
respect to household consumption; and real govern-
ment consumption is linked to real household con-
sumption expenditure (see equations 2-1 and 2-3).
If the shift variable of household consumption is
zero, then the nominal consumption growth rate is
equal to the nominal GDP growth rate, with the con-
sumption ratio and saving ratio unchanged. Further,
since the difference between savings and investment
is, by definition, equal to the current account surplus,
reduction in the investment ratio is brought about by
an exogenous increase in the current account balance
to GDP ratio by one percentage point. In case 3, the
saving ratio and the investment ratio both decline. We
will examine a case where both variables fall by one
percentage point. First, the saving ratio may decline
if the consumption ratio increases . One percentage
point increase in the consumption ratio may be
brought about by an exogenous shock to the shift vari-
able (f3tot). As shown in the simulation in Chapter 2,
its values may be obtained, using equation 2-3: 1.55
% in Korea, 1.46 % in Indonesia, 1.79 % in Malaysia
and 1.56 % in Thailand. Further, since the difference
between savings and investment is the current account
surplus, the saving ratio and the investment ratio may
be lowered by the same amount if the ratio of change
in the current account to GDP is exogenously fixed. It
differs from Chapter 2 in that the current account will
change exogenously. Whereas the saving ratio fell,
but the investment ratio did not decline in Chapter 2,
the investment ratio also declines in this case, lead-
 JBIC Review No.4 113

ing to a completely different result.
The model was closed in following manner. In
order to compare the short-term effect against the
long-term effect, a simulation was carried out for the
case that includes capital accumulation effect in which
induced investment increases capital stock, leading
to an increase in production (long-term effect); and
for the case that does not include this type of capital
accumulation effect (short-term effect). As men-
tioned, changes in the current account balance were
considered an exogenous variable. Also, the country’s
labor input was fixed, while wages were endogenous.
Foreign prices were fixed.
(1) Short-Term Effect (without the capital stock ac-
cumulation effect)
First, let us look at the short-term effect (without
the capital stock accumulation effect) (Table 12). The
investment will decline with a fall in the investment
ratio, but depressed investment flow does not neces-
sarily affect capital stock adversely. It may be con-
sidered that this case looks at the short-term effect
assuming that the decrease in investment can be off-
set by changes in the capacity utilization rate and so
forth.
The effect of one percentage point decline in the
investment ratio will spread as follows. First, the fall
in the investment ratio will result in a sharp drop in
investment by 3.1 % in Korea and Malaysia, 3.8 % in
Indonesia and 2.6 % in Thailand. The lower invest-
ment level will lead to lower domestic demand and a
decline in the price level. The GDP deflator will de-
crease by 1.4 % in Korea, 1.5 % in Indonesia, 0.4 %
in Malaysia and 0.5 % in Thailand. The export prices
also declined by 1.0 % in Korea, 1.1 % in Indonesia,
0.3 % in Malaysia and 0.5% in Thailand, and since
import prices are fixed unchanged, exports will in-
crease and imports will decrease in volume, leading
to current account surplus. Since export prices will
drop and import prices are fixed, the terms of trade
will worsen, the level of domestic welfare will drop,
and consumption will decrease slightly. Therefore,

Table 12 Effect of Fall in Investment Ratio (Short-Term Effect)

(%)
Only Investmenht ratio decline Investment & Saving ratio decline
Korea Indonesia Malaysia Thailand Korea Indonesia Malaysia Thailand
(Change of quantity)
GDP −0.1 0.0 0.0 −0.1 0.0 0.0 0.0 0.0
 Household consumption −0.4 −0.3 −0.2 −0.3 1.5 1.4 1.9 1.6
 Capital formation −3.1 −3.8 −3.1 −2.6 −2.5 −3.2 −2.7 −2.2
 Government consumption −0.4 −0.3 −0.2 −0.3 1.5 1.4 1.9 1.6
 Export 2.7 2.9 0.7 1.1 −0.4 −0.4 −0.2 −0.4
 Import −1.4 −1.9 −0.7 −1.5 −0.2 −0.3 −0.1 −0.2
(Change of price)
GDP −1.4 −1.5 −0.4 −0.5 0.3 0.3 0.1 0.2
 Household consuption −1.0 −1.3 −0.2 −0.3 0.3 0.3 0.1 0.1
 Capital formation −0.9 −1.2 −0.2 −0.3 0.1 0.1 0.1 0.1
 Government consumption −1.3 −1.2 −0.3 −0.5 0.2 0.1 0.1 0.2
 Export −1.0 −1.1 −0.3 −0.5 0.2 0.2 0.1 0.2
 Import 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Change of current account/GDP 1.0 1.0 1.0 1.0 0.0 0.0 0.0 0.0
Labor input 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Capital input 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Wage −1.6 −1.9 −0.7 −0.7 0.2 0.2 0.2 0.5
Rental price −1.4 −2.0 −0.5 −0.6 0.2 0.2 0.2 0.1
Note: Results of model simulation. Effect of one percentage point fall in the investment ratio only and in both investment
ratio and saving ratio. A change in the investment ratio does not affect total capital stock.
114

Table 13 Effect on Production in the Asian Countries (Short-Term Effect)

(%)
Agriculture Mining Manufacturing Electricity Construction Services
Only investment Korea 0.1 0.5 0.8 0.3 −2.8 0.0
ratio decline Indonesia 0.4 0.8 1.0 0.0 −3.6 −0.2
Malaysia 0.1 0.1 0.4 0.1 −2.8 −0.1
Thailand 0.2 0.2 0.2 0.1 −2.6 0.0
Both investment Korea 0.3 −0.6 −0.4 0.2 −2.3 0.7
and saving ratio Indonesia 0.2 −0.2 −0.1 0.8 −3.0 0.6
decline
Malaysia 0.0 −0.1 −0.1 0.4 −2.5 0.5
Thailand 0.1 −0.1 −0.3 0.5 −2.1 0.5

Note: Results of model simulation. Effect of a single one percentage point decline in the investment ratio, and one
percentage point decline in both investment ratio and saving ratio. A change in the investment ratio does not affect
total capital stock.

real GDP will decline by a small amount.
Next, the effect of one percentage point decline
in both investment ratio and saving ratio will spread
as follows. First, investment will fall sharply by 2.5%
in Korea, 3.2 % in Indonesia, 2.7 % in Malaysia, and
2.2 % in Thailand. However, since the saving ratio
also declines and the consumption ratio increases in
this case, household consumption will increase by 1.5
% in Korea, 1.4 % in Indonesia, 1.9 % in Malaysia,
and 1.6 % in Thailand. In other words, the propor-
tion of the components of final demand will shift from
investment demand toward consumption demand, and
any effect that changes domestic demand is neutral-
ized. Therefore, unlike the above case where only
the investment ratio declines, the prices do not nec-
essarily fall. On the other hand, a trend toward ser-
vice economy will accelerate with higher consump-
tion, and demand for factors of production will rise,
resulting in upward pressure on GDP deflator, which
will rise by 0.3 % in Korea and Indonesia, 0.1 % in
Malaysia, and 0.2 % in Thailand. Export prices will
also increase in these countries, thus the terms of trade
will become more favorable, the level of domestic
welfare will not fall, and the effect on real GDP will
be almost nil.
If we compare the first case of a single decline in
the investment ratio with the second case of a decline
in both investment ratio and saving ratio, there is no
significant change in real GDP, but there are signifi-
cant differences in changes in production volume
among industries (Table 13). First, in the case of a
single decline in the investment ratio, investment will
decrease, while exports will increase; therefore pro-
duction will decrease in the construction industry that
primarily produces investment goods, but production
will increase in the manufacturing industry since ex-
port goods account for a large part of its output, and
output will barely increase in the service industry. On
the other hand, in the case with a decline in both in-
vestment ratio and saving ratio, investment will de-
crease and consumption will increase. Here, produc-
tion will decrease in the construction industry, as in
the above case, but output will increase in the service
industry due to a large proportion of consumer goods
in its output, and production will decrease in the manu-
facturing industry.
(2) Long-Term Effect (with the capital stock accu-
mulation effect)
This section will look at the long-term effect (with
the capital stock accumulation effect) (Table 14). This
simulation takes into consideration the effect from
capital accumulation: induced investment increases
capital stock and leads to an increase in production.
Here, investment will decline with a fall in the in-
vestment ratio. Since a decline in investment flow
will lead to a decline capital stock, long-term effect
will prevail.
The effect of a single one percentage point de-
cline in the investment ratio will spread as follows.
First, a decline in the investment ratio will result in a
sharp drop in investment: 5.3 % in Korea, 7.7 % in
Indonesia, 4.5 % in Malaysia and 5.9 % in Thailand.
Due to the lower investment level, in the long-term,
capital stock and investment will drop by the same
rate, which will lead to a decline in supply capacity.
 JBIC Review No.4 115

Table 14 Effect on the Economy of Fall in Investment (Long-Term Effect)

(%)
Only Investment ratio decline Investment & Saving ratio decline
Korea Indonesia Malaysia Thailand Korea Indonesia Malaysia Thailand
(Change of quantity)
GDP −2.6 −4.0 −2.5 −4.1 −2.1 −3.4 −2.2 −3.4
 Household consumption −2.6 −3.6 −2.0 −3.6 −0.3 −1.4 0.3 −1.2
 Capital formation −5.3 −7.7 −4.5 −5.9 −4.3 −6.6 −4.0 −5.0
 Government consumption −2.6 −3.6 −2.0 −3.6 −0.3 −1.4 0.3 −1.2
 Export −0.1 −1.4 −2.0 −2.7 −2.6 −3.9 −2.6 −3.6
 Import −3.0 −4.5 −2.5 −3.8 −1.6 −2.5 −1.7 −2.1
(Change of price)
GDP −0.4 1.1 1.2 1.1 1.1 2.5 1.5 1.5
 Household consumption −0.5 0.7 0.6 0.6 0.8 2.0 0.8 0.8
 Capital formation −0.1 1.3 0.4 0.8 0.8 2.3 0.6 0.9
 Government consumption −1.2 1.7 0.2 −0.2 0.3 2.7 0.5 0.5
 Export 0.1 0.6 0.8 1.1 1.0 1.6 1.0 1.5
 Import 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Change of current account/GDP 1.0 1.0 1.0 1.0 0.0 0.0 0.0 0.0
Labor input 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Capital input −5.6 −8.1 −4.6 −6.0 −4.5 −7.0 −4.1 −5.1
Wage −2.6 −1.6 −0.6 −2.2 −0.6 0.5 0.3 −0.9
Rental price 2.6 6.0 3.9 3.1 3.4 7.1 4.1 3.2

Note: Results of model simulation. Effect of a single one percentage point decline in the investment ratio, and a one
percentage point decline in both investment ratio and saving ratio. A change in the investment ratio is directly
translated into a change in total capital stock.

While a sharp drop in imports will lead to current
account surplus, real GDP will also decline by 2.6 %
in Korea, 4.0 % in Indonesia, 2.5 % in Malaysia and
4.1 % in Thailand.
The effect of one percentage point decline in both
investment ratio and saving ratio is similar to the
above case: investment will decline by 4.3 % in Ko-
rea, 6.6 % in Indonesia, 4.0 % in Malaysia and 5.0 %
in Thailand, with capital stock level declining respec-
tively. However, a rise in the consumption ratio will
limit change in household consumption to a decline
of 0.3 % in Korea, 1.4 % in Indonesia, an increase of
0.3 % in Malaysia and a decline of 1.2 % in Thailand.
Therefore, the drop in real GDP will be smaller com-
pared with the above case where only the investment
ratio declined. GDP would decline by 2.1 % in Ko-
rea, 3.4 % in Indonesia, 2.2 % in Malaysia and 3.4 %
in Thailand.
In summary, if we consider the short-term effects
where a drop in new investments can be offset by a
change in capital utilization rate and so forth, the ef-
fect on GDP is almost neutral. But if we consider the
long-term effect including the effect of capital stock
accumulation, the negative effect on GDP will be
greater for each country. Even in the latter case, how-
ever, the negative effect can be alleviated when the
consumption ratio increases rather than when capital
outflow occurs with current account surplus.
With regard to the effect on industries, the short-
term effect will lead to an increase in production in
some industries and a decrease in others. In particu-
lar, when both investment ratio and saving ratio de-
cline, production will decrease in the manufacturing
industry and increase in the service industry, indicat-
ing a trend toward service economy. However, if a
decline in the investment ratio continues and eventu-
ally affects the level of capital stock, production will
decrease across all industries even if there may be
some variation in the extent of decrease among dif-
ferent industries, regardless of whether the saving ratio
falls or not (Table 15). Although in the short-term,
the service industry will benefit from drop in the in-
116

Table 15 Effect on Industries of Fall in Investment (Long-Term Effect)

(%)
Agriculture Mining Manufacturing Electricity Construction Services
Only investment Korea −0.5 −1.8 −2.1 −2.7 −5.1 −2.8
ratio decline Indonesia −1.4 −1.8 −4.0 −4.3 −7.5 −4.6
Malaysia −1.0 −1.5 −2.7 −2.7 −4.3 −3.0
Thailand −0.7 −2.4 −4.6 −4.0 −5.8 −4.1
Both investment Korea −0.3 −2.5 −2.7 −2.3 −4.1 −1.6
and saving ratio Indonesia −1.3 −2.4 −4.3 −2.8 −6.4 −3.1
decline
Malaysia −1.0 −1.5 −2.9 −2.1 −3.8 −2.2
Thailand −0.7 −2.3 −4.3 −3.1 −4.9 −3.0

Note: Results of model simulation. Effect of a single one percentage point decline in the investment ratio, and one
percentage point decline in both investment ratio and saving ratio. A change in investment ratio is directly
translated into a change in total capital stock.

vestment ratio and the saving ratio, their prolonged
decline will also affect it in term of decreased level
of capital stock. Naturally the impact will vary, de-
pending on the degree of change in the saving ratio.
CONCLUSION
This paper used an applied general equilibrium model
and examined how several changes in the conditions
in the East Asian region had impacts on these econo-
mies and their industrial structures before and after
the currency crisis.
If one uses a theoretical model, it is only pos-
sible to know whether a variable would take a posi-
tive or negative direction. An applied general equi-
librium model, however, has a major advantage in
that numerical information can be fed into it, thus al-
lowing us to examine not only the direction but also
the extent of change. Further, when one economic
measure produces a positive effect on a certain vari-
able while another has a negative effect, the theoreti-
cal model may fail to grasp even the direction of its
change resulting from their combined effect. An ap-
plied general equilibrium model, on the other hand,
may capture the combined effect of different mea-
sures because it can account for the quantity of change.
In cases where there is theoretical knowledge but it is
hard to figure out how the economy would evolve in
the realistic setting, an applied general equilibrium
model is a powerful tool for making simulation ex-
periments. In particular, it is a tool befitted to the
analysis of growth in East Asia where the industrial
sector may be further divided into many industries
and structural change is deeply involved in the pro-
cess of economic growth.
Until the currency crisis broke out in 1997, East
Asia had sustained high growth for a long period. The
export-led industrialization, for which the region’s
economies strived, linked an increase in the supply
that makes use of domestic surplus resources with
rising export demand, thereby contributing to the eco-
nomic success of East Asia. Since foreign demand
was much larger than the economic scale of the re-
gion, the constraint to growth imposed by inadequate
domestic demand was removed. In the area of labor
supply, there was cheap and abundant surplus labor
in the agricultural sector, and the quality of labor force
improved significantly because of the better primary
education system. In the area of capital stock accu-
mulation, resources were allocated intensively to the
manufacturers of export goods by using all available
means, while the promotion of direct investment ac-
celerated inflows of foreign capital and technology.
Resources are not infinite, however, and growth
driven by increased factor inputs, which character-
ized East Asian economic growth, has to face a major
turning point. In ASEAN countries, increased factor
inputs largely contributed to economic growth and
we could not confirm that labor input lost steam be-
fore the crisis. In contrast, expansion in labor input
markedly slowed down among NIES from the mid-
1980s and, in particular, in the manufacturing sector,
it came to a complete halt.

Chapter 1 looked into whether export-led indus-
trialization is sustainable, and shed light on the mecha-
nism of transition from industrialization to a service
economy. As economy expands, a labor surplus
economy evolves into a labor shortage economy, caus-
ing upward pressure on the wage level. If wages rise
faster than growth, so does the household income with
increasing labor share in income distribution, thus
rapidly boosting demand in the service sector. The
wage hike will also undermine the international com-
petitiveness of the labor-intensive manufacturing sec-
tor, which, in turn, will put a brake on export growth.
A rise in the allocation of income for the household
will trigger a dramatic move for the service indus-
tries, since structure differs greatly between consump-
tion demand, which has a large share of the service
sector, and the export demand, which is dominated
by goods.
The extent of the pressure for expanding the ser-
vice sector varies from country to country. It is
strongly felt in NIES. If exports are to increase un-
der such circumstances, the focus of resource inputs
should shift from labor, whose cost has risen, to capi-
tal; output should increase with fewer inputs by im-
proving productivity; and competitive edge should
be maintained by curbing a rise in prices. To sustain
the export-led industrialization, such a “gear-shift”
was necessary.
In the second half of the 1980s and thereafter,
Korea sought to expand exports by pursuing the
economies of scale. As a result, capital inputs rose in
the manufacturing sector, leading to a rise in TFP.
However, since TFP growth in the service sector re-
mained low, the export sector had to raise its level of
investment and productivity. The ratio of investment
to GDP thus increased despite the higher share of
consumption and lower saving ratio, which brought
about excessive reliance on capital inflows from over-
seas. One cannot deny the possibility that this led to
the Asian currency crisis. NIES have already entered
the stage where even greater significance should be
attached to how to convert the stimulus from domes-
tic demand to economic growth. Productivity should
have increased not only in the export goods indus-
tries but also in the domestic goods industries and in
particular the service sector in order to achieve a well-
JBIC Review No.4 117
balanced growth.
The currency crisis that erupted in the summer
of 1997 in Thailand spread later to Korea, Indonesia,
Malaysia and the Philippines. These countries could
not sustain capital inflows, and thus drastic capital
outflows, largely short-term funds, took place. The
exchange rates also depreciated on a massive scale.
Ironically, capital movements from overseas that had
underpinned the robust growth until then became a
background of the crisis. Economies previously ad-
mired worldwide for high growth exposed a number
of vulnerabilities, bringing a turnaround toward sub-
stantial negative growth in 1998. Entering 1999, how-
ever, the economies affected by the currency crisis
rebounded and registered V-shaped recoveries well
beyond the expectations. Capital outflows after the
crisis caused exchange rate depreciation, which af-
fected the financial sector adversely with soaring non-
performing assets but contributed to the economy
through an increase in exports with additional help
from the bustling US economy and a global increase
in IT demand.
Chapter 2 examined the impact of exchange rate
depreciation on individual economies and how much
contribution it has made to their economic recover-
ies. According to the simulation, once the crisis phase,
where investment returns suffer an extreme decline,
passes and the economy is back to the normal phase,
the exchange rate depreciation does have a signifi-
cant effect. It should be noted, however, that the re-
sult was based on the assumption that there is no con-
straint in labor input and that the real exchange rate
also depreciates, with the inflation rate less than the
rate of nominal exchange rate depreciation. Because
of the recession immediately after the crisis, the gap
between supply and demand widened; the capacity
utilization rate fell; and unemployment soared. This
situation largely helped firms to hire employees with-
out raising the wage level during the recovery pe-
riod. As the deflation gap is being eliminated and
wages rise, the depreciated nominal exchange rate will
gradually lose its effect. In this sense, the effect of
exchange rate depreciation should be considered only
temporary.
Chapter 3 dealt with the effect of changes in in-
vestment trends after the crisis, examining the im-
118
pact on potential growth when investment will not
recover. Recently a increasing number of observers
have come to hold a view that as a result of the V-
shaped recovery, the Asian currency crisis is already
behind us. To be sure, production and employment
have surpassed the pre-crisis levels in some countries,
and in this sense we may say that the crisis is over.
But when we compare growth between the pre- and
post-crisis period in detail, we will find its growth
pattern vary greatly between the two periods.
In East Asia, there is no doubt that capital accu-
mulation took place at a rapid pace during the high
growth period, leading to greater supply capacity and
ensuring fast growth. Brisk investment demand was
supported by an increase in domestic saving and
capital inflows from overseas. However, in the af-
termath of the Asian currency crisis, investment suf-
fered a precipitating fall from the previous high lev-
els and international capital movements shifted from
net inflow to net outflow. Growth after the crisis
was mainly propelled by an increased contribution
of foreign demand, with a substantially declined
contribution of investment. One of the reasons for
the fall in investment was the collapse of the bubble
created by unprofitable investment in real estate;
excessive investment in anticipation of high growth,
which increased non-performing assets; and contin-
ued outflows of short-term capital by foreigners. The
cost of disposing non-performing assets will even-
tually have to be paid out of GDP growth. There-
fore, funds to be allocated to investments in other
circumstances will likely be channeled to repay non-
performing assets. In addition, both investors and
recipients may well be very cautious about renewed
inflows of short-terms capital for the foreseeable
future, and capital outflows may not be halted. It is
at least difficult to consider turning to overseas short-
term funds for financing investment as in the mid-
1990’s.
The present pattern of growth may be summed
up as a reaction to a steep fall due to the crisis, indi-
cating that the economies are merely going through
an adjustment period. They have not recovered in
the sense that they have returned to the structure
which enabled them to bring back the high growth
of the pre-crisis period. If economic recovery trig-
gered investment to return to previous highs, then
the Asian currency crisis may only be seen as a tem-
porary setback without posing a significant prob-
lem in the potential growth for the Asian economies.
However, if investment motives do not recover as
the countries face problems addressing the non-per-
forming assets and the collapse of the bubble, its
impact will be considerable on the Asian economies
that have relied much on capital accumulation (es-
pecially physical capital) among factors for high
economic growth. In the short run, this may not
emerge as a distinct problem since a fall in invest-
ment growth is offset by increased foreign demand.
But in the longer run, it may be considered that this
will lead to a decline in potential growth rate. The
first step toward new sustainable growth after the
crisis is to make the maximum effort to reform eco-
nomic structure in individual countries, particularly
to strengthen their financial system by making fur-
ther progress in addressing non-performing assets;
to promote foreign capital inflows with a focus on
increasing direct investments through deregulation
as well as relaxation of regulations with respect to
foreign businesses in the domestic market; and to
improve the efficiency of business operations in the
corporate sector.
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