Attracting dollar without risk

Attracting dollar without risk

By C.J. de Koning

This is the first of two articles on the Indonesian monetary
crisis.

JAKARTA (JP): Prominent economist Prof. Dr. Soemitro
Djojohadikoesoemo called recently for a lowering of rupiah
interest rates because the current rates of over 58 percent are
stifling the local economy.

Former minister of finance Mar'ie Mohammad also recently
called for a reintroduction of a managed floating exchange rate
for the rupiah against the U.S. dollar.

Last year's loan package arranged for Indonesia by the IMF
carried as an assumption that the rupiah-U.S. dollar exchange
rate would stabilize around the Rp 6,000 level during the course
of this year. In the latest agreement between the IMF and the
Indonesian government an exchange rate of Rp 10,000 to the dollar
is assumed. The rupiah is currently trading at over Rp 15,000 to
the U.S. dollar, an exchange rate which has forced 70 million
Indonesians below the poverty line.

Exchange rates, interest rates, local prices and the local
economy are inextricably linked.

Many economists base their advice on the theory that if you
increase local currency then interest rates substantially. The
savings ratio will then increase both from domestic and foreign
sources, and local consumption, imports and investment levels
will drop because borrowing has become more expensive.

High interest rates will also cause the rupiah to strengthen
against the dollar because overseas savings which are converted
into local currency will increase the supply of dollars and
thereby strengthen the rupiah. Furthermore, the excess production
capacity created by reduced local demand can be used to increase
exports.

It is clear that the assumed exchange rates of at first Rp
6,000 and later Rp 10,000 have not been achieved in practice
because markets behave differently to the way theory would have
us believe.

To understand why this is so we must first consider what
factors determine the rupiah-dollar exchange rate.

The exchange rate is determined by trade flows consisting of
Indonesian export income and import expense, and by capital flows
to and from Indonesia which together determine the supply and
demand for foreign currency in this country.

Capital outflows are loan and interest (re)payments, outward
bound portfolio investment and disinvestment by foreigners both
from the local stock market, directly owned companies and
individual assets, plus free transfers into a foreign currency.

Capital inflows are loans from the IMF, World Bank, Asian
Development Bank and foreign commercial banks, as well as money
from international depositors. Foreign investments in the local
stock market or in any other local asset base (company or real
estate) also bring in foreign currency.

We may also consider some of the changes in behavior patterns
by the various groups who have been operating in Indonesia's
economy since June last year.

Foreign lenders (i.e. foreign banks) have in general taken a
more cautious view of events in Asia since the Thai economic
slide began. This in practice meant less foreign currency credit
and therefore a higher net demand for dollars out of existing
debt positions as supply reduce and demand increased.

If -- as in Indonesia's case -- short term foreign currency
debt dominates the corporate and local bank debt schedule, then a
shift by foreign banks from continued lending to reducing
outstanding claims led to a heavy demand for U.S. dollars.

It may be estimated that some US$35 billion to $40 billion in
debt servicing became due between July 1997 and June 1998,
against which only $10 billion in new loans were granted. These
figures require fine tuning if a better record of capital inflows
and outflows is to be maintained.

On the trade financing front, foreign lenders reduced their
combined exposure on local banks from $13 billion in October last
year to $4 billion on April 30 this year.

Foreign investors in the Jakarta stock market have also cut
back their activities. In June last year the Jakarta stock market
had a value of $100 billion. By the end of June this year the
value had fallen to $14 billion.

Foreign investors in companies and to a much smaller degree
investors in real estate or local currency began to exercise more
caution after political and economic turmoil increased. Foreign
direct investment levels and foreign inflows into the local
currency decreased as a result.

Many companies and local banks borrowed money in U.S. dollars
and used these funds to finance operations in rupiah. The
companies estimated the exchange risk for the rupiah-dollar at 5
percent per annum and the interest gain at 20 percent to 25
percent per annum, leaving a positive risk margin of 15 percent
to 20 percent per annum. All this changed when the rupiah was
freely floated, but it should be pointed out that at the time,
the assumptions about exchange rate depreciation were made in
accordance with official government policy.

Many local banks had open currency positions. As the rupiah
depreciated and local interest rates increased, they had to
convert more rupiah to get the same number of dollars. These
rising costs could no longer be fully transferred to the
borrowers, leading to substantial loan loss provisions and in
some cases to liquidity losses, bank closure or transfer to
Indonesian Bank Restructuring Agency supervision.

The final group of players are local people. The closure of 16
banks on Nov. 1, 1997, increased uncertainty and damaged
confidence, especially since initially there were no arrangements
made to compensate these banks' depositors. This uncertainty led
to a flight into U.S. dollars, some of which went overseas. Again
it is very difficult to guess how much capital left the country
or was changed into U.S. dollars, but it was not an insignificant
amount.

The clear conclusion from the above is that the supply of
foreign currency fell substantially at the same time as demand
increased dramatically.

The writer is Country Manager Indonesia for ABN AMBRO Bank.
This article was written in a personal capacity.