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.