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.