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.