Assets: Getting value for money

Assets: Getting value for money

By C.J. de Koning

The following is the first of two articles on Indonesia's
economic crisis.

LONDON (JP): If someone buys a house in Indonesia, it would be
rare that he could afford the whole purchase price. He would
normally go to the bank and obtain a loan. If a domestic airline
in Indonesia buys a plane, it would be equally rare that the
company could afford to pay the whole amount up front. The
company would also take out a loan.

If the Indonesian government wants to build ports, bridges,
power stations, it takes out foreign currency loans.

Assets -- land, houses, planes, ports, machines, stocks,
debtors -- are all tangible items or financial claims on others
that individuals, companies and the government have at any
specific moment in time. Liabilities -- debt and equity -- are
the sources of funds with which such assets are financed.

Assets, when they are used, create cash flow and employment.
For instance, a domestic airline flies from Jakarta to Surabaya
and back. It sells seats on the plane. How often the plane flies
depends on technical limitations and on demand and supply -- the
price. It furthermore depends on the management's capabilities to
organize the operations properly.

The availability and continued use of liabilities -- a.o. bank
loans and equity -- depend on risks, especially perceived risks.
For instance, if someone loses his job and can no longer afford
to pay the mortgage, the bank may sell the house. If a company
can no longer afford to pay for the plane, its share price will
drop and the plane may also be sold off.

In these simple examples all elements of economic growth are
hidden. They are assets, liabilities, technical constraints,
cash flow, employment, markets, equity values and management
skills.

Indonesia's total assets -- equal to equity plus debt levels
-- stood at US$419 billion as of June 30, 1997, just before the
crisis started. As of June 30, 1998 total asset value had dropped
to $225 billion. An economic loss of $194 billion.

Assets can contribute to output for many years. For Indonesia,
one can estimate that the average lifespan of assets is eight
years.

This means that the cash flow has to be able to earn $52
billion a year for eight years in order to replace all the
assets, except land. It also means that output can continue to be
produced at the same level for eight years. Indonesia's output
value was running at $200 billion over 1997. Up until June last
year, output was growing at a rate of 8 percent per annum. The
number of years that output can be produced economically and
efficiently with the assets available may be called "the economic
lifespan of assets".

Under normal economic growth circumstances, one can expect
that both output and asset values increase. The realized figure
for Indonesia, however, shows another picture -- a loss in asset
value of $194 billion for the year up to June 30, 1998. It shows
that Indonesian assets depreciated over a period of two years and
two months. For convenience sake say two years. The number of
years that assets are actually written off can be called "the
financial lifespan of assets".

This difference between economic and financial lifespan
constitutes the core element in understanding what went wrong
with Indonesia's economic growth.

The economic lifespan of assets tends to lengthen the more a
country invests in its infrastructure. It is unlikely to shorten
very much or fluctuate greatly in the short run. Also management
skills do not change rapidly in the short run.

In other words, the value loss of assets of $52 billion over
one year may fluctuate somewhat but within narrow margins. On the
other hand, risk perceptions on funding the assets can change
dramatically in the short run. The experienced value loss of
assets -- $194 billion -- was caused to a very large degree by
this change in risk perception.

All financial, company and stock exchange evidence suggests
that lenders and equity providers withdrew from funding the
assets. The cash flow needed for satisfying lenders and equity
providers far outstripped the $52 billion needed to continue
economic activities at the same level as before. Financial
considerations -- the funding side of Indonesia's balance sheet
-- ran the economy rather than the asset side. In the year to
June 1998, the funding side created a deep recession.

When the funding side shortens the lifespan of assets an
enormous waste of assets is created, which is economically highly
inefficient. Assets that could produce output for eight years
economically and efficiently, are all of a sudden required to
make its earnings in two years. Of course this cannot be done.
Output drops dramatically.

If the aim is to maintain economic growth and avoid recession,
then the financial lifespan has to be extended to a level more or
less equal to the economic lifespan. The latter cannot be
adjusted rapidly but the former can. In this connection one has
to note that financial markets adjust in a very inefficient
manner.

For instance, if one party withdraws funds from a company or a
country, the risks for all others increase. If such a withdrawal
is in U.S. dollars -- as 65 percent of all loans provided in
Indonesia are in U.S. dollars -- then the exchange rate is
affected. Such depreciation of the rupiah affects the risk
perceptions of all other U.S. dollar lenders and subsequently
rupiah lenders as well. The process is a self-strengthening
process rather than a self-correcting mechanism. Also the changes
in risk premium cannot easily be applied to all outstanding
loans. The price mechanism for risks works very poorly and as a
consequence withdrawal from risks rather than staying with the
risk at a higher risk premium is nearly always given priority.

Second, why do risk perceptions change? The simple answer is:
changes in cash-flow patterns. Cash flow is based on sales price
and cost levels. Any sales price reduction or increase in costs
affect risk perceptions. The strong rupiah depreciations of the
past years and the large interest rate cost increases, from 20
percent to over 70 percent, all affect risk perceptions.

The writer is former country manager ABN AMRO Bank in
Indonesia as is currently with ABN AMRO London. This article was
written in a private capacity.