A way out of the liquidity crisis

A way out of the liquidity crisis

By C.J. de Koning

This is the first of two articles on a proposed solution to
Indonesia's liquidity crisis.

JAKARTA (JP): Correctly identifying the basis of Indonesia's
liquidity crisis is essential in determining the best method to
reach a solution.

A recently published document by the World Bank, Indonesia in
Crisis (Washington, July 16, 1998), says: "The crisis, after all,
is a crisis of confidence in the rupiah. Throw more rupiah at
indebted corporations and banks and the exchange rate will
depreciate rapidly, sending the economy into hyperinflation.

"And the government cannot throw more dollars at the problem
either because the country's short term external liabilities far
exceed liquid foreign exchange reserves and, unsurprisingly,
international market sentiment precludes commercial borrowing
abroad in large amounts."

The report concludes: "So there is little alternative to
restoring confidence except the old-fashioned way -- earning it."

Even though the World Bank analysis describes the crisis as a
rupiah currency crisis, a better description would be that it is
a U.S. dollar liquidity crisis.

Does it really matter whether we call the crisis a U.S. dollar
liquidity crisis or a rupiah currency crisis?

A rupiah currency crisis would result in high local inflation
levels, either from excessive government spending, local
consumption, local investment or excessive increases in wages.

Such local "cost" factors hamper companies in their exports
and induce others to import more at stable exchange rates. The
foreign currency earnings out of international trade and services
are negatively affected in such a case. The country has a
"comparative cost" problem. Solving this problem requires a
depreciation of the rupiah and an increase in rupiah interest
rate levels to dampen local demand.

When the crisis started in Indonesia in August last year, none
of these local "cost factors" were out of balance to any
significant extent. It, therefore, can be concluded that the
current crisis in Indonesia is not a rupiah currency crisis.

But what else could have caused the crisis? In order to answer
this question, one has to analyze the behavior of foreign fund
providers to Indonesia (the capital flows in and out of the
country).

Foreigners have provided or received foreign currency funds
which have been invested in, lent to or received from Indonesian
assets. For convenience sake, these flows can be referred to here
as "investment and disinvestment flows".

Such assets were shares listed on the Jakarta Stock Exchange,
loans to the Indonesian government, banks and companies or
investment in real estate or any asset for that matter.
International savings in foreign currencies were used to
complement rupiah savings. U.S. dollars and rupiah worked side by
side in the Indonesian economy -- a true example of a dual
currency economy.

Based on an analysis of the financial crisis, the substantial
withdrawal of foreign currency funds out of the economy over the
last nine months was and is the main cause of the crisis.
Foreigners withdrew substantial funds out of the Jakarta Stock
Exchange over the last year. Foreign lenders also withdrew
substantial funds from Indonesian banks and companies over the
same period.

For instance, in international trade finance alone, US$9
billion was withdrawn and not replaced in the period from October
1997 to April 1998. This was out of an outstanding amount of $14
billion, only in October last year.

This net dollar cash outflow could not be fully covered by the
foreign currency cash positions of Bank Indonesia, local
commercial banks and local companies. The domestic rupiah economy
had to come up with the foreign exchange cash from export
earnings, which it basically could not do at the pace the dollars
were required.

The rupiah exchange rate had to give way -- and was allowed to
give way -- under the new free floating foreign exchange regime
introduced last August. It did so and dramatically overshot,
creating negative consequences of high imported inflation levels,
many local corporate bankruptcies and a total collapse of the
construction sector to mention just a few.

To better understand how important such withdrawals were, one
has to realize that for any foreign currency cash amount that was
provided in the past to Indonesia, there was always a local
asset. Foreign currency cash has been used to provide equity
capital to Indonesian companies and these companies used the
money to build factories and other facilities.

Foreign currency cash was lent to domestic banks, which passed
on the funds to exporters and importers, among others. Foreign
currency cash was directly lent to Indonesian companies again to
buy machinery and build factories, offices, power plants,
chemical plants, toll roads and many more assets. Foreign
currency cash was also lent to the government, which used it for
building harbors, bridges and all other development projects the
private sector did not take an interest in.

Indonesian assets funded with international rather than
domestic savings have -- like all assets -- a cash flow
generating ability. However, technical as well as market
constraints make it very difficult to greatly speed up such an
ability.

In simpler words, a machine cannot produce in one year what it
is meant to do in five years. Also a complete redirection of
production and sales from domestic to international markets
cannot be achieved within a very short period of time.

Assets require time to be converted into dollars and if in
this time they are not available, then a full-blown dollar
liquidity crisis occurs. Basically such a crisis is a
macroeconomic "mismatch" crisis, whereby the assets are on one
type of cash-flow conversion schedule and the funding all of a
sudden on another type -- and, of course, a much faster cash-flow
generation is required.

And if such funding has come from abroad and is demanded back
by foreign parties faster than the assets can generate a cash
flow, then the exchange rate suffers a dramatic fall -- a fall
based on the dollar liquidity situation rather than on
comparative costs.

The writer is the country manager of ABN AMRO Bank. The
article has been written in a private capacity.

Window: Assets require time to be converted into dollars and if
in this time they are not available, then a full-blown dollar
liquidity crisis occurs.