Mon, 11 Nov 1996

Camdessus' advice

The two biggest challenges in the financial sector which IMF Managing Director Michel Camdessus says are facing the ASEAN countries in today's global economy are precisely the problems Indonesia is coping with at present. The challenges, according to the chief of the International Monetary Fund, who addressed a conference on macroeconomic issues in the ASEAN countries in Jakarta last week, are related to the sustainability of large current account deficits and the soundness of domestic financial systems.

Earlier, in his analysis, Camdessus reiterated the secrets of the success of most ASEAN countries in achieving high, sustainable rates of economic growth. Among the most important factors are prudent fiscal policies, high domestic savings and an attractive investment climate. Other important ingredients which have made the high growth not only sustainable but also of a high quality include an outward-oriented and market-friendly strategy, strong emphasis on infrastructure investment and anti-poverty programs.

The challenge related to the current account deficit was caused by the globalization of the international financial markets and by the very success of the ASEAN countries, including Indonesia, in terms of attracting large sums of capital inflows. The problem arises because quite a significant portion of the inflows often consists of short-term capital, which can suddenly fly out either because of wild rumors, contagion effects or changing financial market conditions in other markets. The large inflows tend to raise aggregate expenditures and increase inflationary pressures, thereby widening the current account deficits.

Many countries in this region obviously still remember the burden they suffered from the impact of the financial crisis in as far away as Mexico in early 1995. Indonesia itself was then forced to draw down more than US$500 million from its foreign reserves to defend the rupiah against currency speculators. Smaller waves of currency speculations occurred over the past 18 months. The government has taken several measures to curb short- term capital flows and to attract more foreign direct investment. Direct investment is more stable because it is not influenced by short-term outlook, but instead looks more at the fundamentals of the economy.

The central bank's move last September to widen the exchange rate band of the rupiah against the American dollar to 8 percent was designed specifically to help curb currency speculation.

Bigger challenges, however, remain with regards to the soundness of the domestic financial system, notably the banking industry. The enforcement of the prudential banking rulings has yet to be strengthened. Bank Indonesia's Governor, Soedradjad Djiwandono, admitted that many banks still failed to conform with the legal lending limits and the loan-to-deposit ratio.

Soedradjad has warned that the central bank would not hesitate to take action against banks violating the prudential regulations, but the warning apparently needs to be translated into actual measures. Many analysts suspect that the central bank is not as powerful as its counterparts in other countries in dealing with politically well-connected banks. The matter is often complicated by the special characteristics of banks, which do not allow the central bank to publicly disclose what measures it is taking against problem banks.

However, as Camdessus noted, problems in the financial sector cannot be prevented by prudential regulations alone. Appropriate, firm monetary and fiscal policy measures are required before a problem bank deteriorates to the point that forces the central bank to launch a bail-out in a bid to prevent the systemic risk of a bank failure. Given the fiduciary responsibility of banks and the multiplicity of transactions they are usually engaged in, the failure of a bank usually hurts a large number of depositors and could trigger a domino-like collapse of many other banks and their corporate customers. But it is precisely because of the systemic risks that the central bank should act firmly and indiscriminately against problem banks.