Can half a program succeed?

Can half a program succeed?

With the IMF aid package for Indonesia in place, why is the
current financial crisis deepening? ABN-AMRO Bank country manager
C.J. de Koning examines the question in the following article.

JAKARTA (JP): While reading the full text of the IMF agreement
with Indonesia, I got the clear feeling that I was only reading
half a program.

In order to understand my feeling, let me try to explain how I
think the Indonesian financial crisis developed.

The Indonesian private sector has a foreign currency debt
level of about US$65 billion. Nearly all of this was borrowed
from foreign banks with another $15 billion arranged via the
capital market. The average rate of maturity of all these debts
is approximately 1.5 years, which means that in 1998, companies
are expected to pay $59.8 billion in interest and principal to
foreign lenders.

During the first six months of 1997, the private sector was
doing business under the assumption that the rupiah would
depreciate by about 5 percent per year, and that maturing loans
could be rolled over or replaced by new loan facilities.

Under these assumptions, many companies took out dollar loans,
converted them into rupiah and kept the currency risks open.

When the Thai crisis emerged, some companies started to cover
their currency risks by the end of July 1997. The assumption of a
5 percent depreciation of the rupiah started to look a bit shaky.

During August and September, more and more companies started
to cover their currency risks as the rupiah started to be
affected more seriously. By Oct. 3, the rupiah reached Rp 3,800
to the U.S. dollar. After the government closure of 16 private
banks in the beginning of November, the rupiah started to fall
more rapidly as many companies started to look for dollars to
cover their debts. They became convinced at that time that the
rupiah would never return to the old exchange rate of Rp 2,450 to
the dollar.

The outlook became even more uncertain. Private individuals
started following the business trend and exchanged their rupiah
for dollars. This created heavy demand for the dollar. Jan. 8 saw
the rupiah crumble below the Rp 10,000 level. As of Friday last
week, the exchange rate had strengthened to Rp 8,200, but this
week has seen it dive to new lows of below Rp 12,000 to the
dollar. On top of all this, many foreigners who had been
substantial investors in the Jakarta Stock Exchange also moved
out and moved back to dealing in dollars.

With the increased demand for dollars from local companies,
private individuals and foreign portfolio investors who exchanged
rupiah equities back into dollars, total demand for dollars grew
very rapidly. Finally, foreign banks also saw their credit risks
increasing rapidly due to the fall of the rupiah. They started to
rein in new lending, first to companies and later to Indonesian
banks.

Export earnings, however, continued to climb relatively
steadily over the last six months at a pace of about 12 percent
per year. But the rapidly increasing demand for dollars coupled
with a diminishing supply of dollars by foreign banks both to
companies and local banks, created a significant imbalance in the
supply and demand for U.S. dollars, with dramatic consequences
for the dollar-rupiah exchange rate.

The key to this was and still is that private sector companies
have foreign currency loans of $80 billion and have debt
servicing obligations of some $59.8 billion in 1998. In general,
it can be said that very few companies in the world are able to
generate sufficient cash flow to repay three-quarters of their
debts in debt service in a single year. Indonesia is no
exception. The maturity profile of private sector debt is just
unrealistically short. The uncertainties in the foreign exchange
market have aggravated the problem further.

All parties, including local corporations, foreign portfolio
investors, individuals and foreign banks reacted rationally from
their individual point of view due to the uncertainty levels.

The question is, did all private sector parties collectively
react appropriately?

It is quite clear who were the leaders and who were the
followers in this process. The corporate sector was clearly the
leader in the demand for U.S. dollars. Portfolio investors,
private individuals and foreign banks only reduced their rupiah
exposure if the positive yield differential between the rupiah
interest rate and the dollar interest rate was no longer expected
to cover the depreciation risk of holding on to rupiah assets.
Foreign banks reacted to deteriorating abilities to pay when the
rupiah depreciated rapidly.

The error -- if we can call it an error -- was that the
assumptions of the corporate sector and foreign banks proved to
be wrong by using the wrong maturity profile of foreign currency
debts of the Indonesian private sector. These debts were agreed
to between lenders and borrowers. However, the maturity profile
was out of tune with the ability of many corporations to pay, and
with the country's ability to pay.

A financial crisis has developed out of unfounded assumptions
made by foreign banks, international capital markets and local
borrowers.

The financial imbalance of the corporate sector's demands for
dollars and the country's supply has clearly led to an economic
crisis with the expectation of a zero percent economic growth
rate, 20 percent inflation and increasing unemployment for 1998.
Furthermore, a local banking crisis has been added to the list of
the country's problems recently. Acute social hardships -- if no
corrective action is taken -- may also occur.

Since the cause of the current crisis lies in the cash flow
demands of the lending-borrowing relationships between foreign
banks and international capital markets on the one hand and the
Indonesian private sector on the other, it is also logical, that
the solution must be found through the same relationship.

The financial policy aim can be easily identified: Keep most
Indonesian companies and Indonesia as a nation in a positive
foreign currency cash flow rather than in a negative cash flow
situation. Foreign portfolio investors, individuals and foreign
banks would all likely follow suit.

Now return to the original question: Can half a program
succeed?

The IMF program can be seen as half a program since it does
not directly address the fundamental question of how to keep
Indonesian companies in positive foreign currency cash flow
positions.

The IMF program for Indonesia addresses many structural
reforms, including for the banking sector. But since it is
designed to enhance the country's economic efficiency over time,
how many companies will be left to take advantage of it? The IMF
makes foreign currency loans available to the government, but
these funds are not meant to go to the private sector. The funds
are meant to support the government to raise confidence in the
rupiah.

Maybe it is not within the IMF's duties to maintain the
financial health of the Indonesian private sector, but in order
to get the country back on its feet, the private sector's crisis
should get at least equal priority if not higher than the
structural reforms. A program for both is needed. Over time,
getting companies back on their feet leads to a much faster
return to healthy economic growth rates, low inflation and a much
stronger rupiah.

Indonesia's crisis is, as stated, first and foremost a
financial crisis of the private sector. The first half of a
program should therefore be directed to solve this private sector
crisis. The second half (the IMF-Indonesia agreement) would only
work well if it was executed in tandem with the first half of the
program.

Again, the key cause of the private sector crisis came from
its assumptions of a 5 percent rupiah depreciation per annum and
the expectations that it could roll over foreign debts.

The solutions lie in the foreign currency debt profile of the
private sector and of the country as a whole. No country can
generate $59.8 billion in one year out of an $80 billion debt.
Indonesian companies have in the past shown an ability to earn
back their debts, varying on the type of industry, in about three
to five years. This would still require $28 billion in debt
service ($20 billion in principle and $8 billion in interest) in
1998. On top of this comes the government debt service of $7.8
billion.

Under the current fragile conditions, these amounts may or may
not be possible to finance for the country as a whole. Confidence
is the key to success and therefore I propose an arrangement in
which Indonesian companies would settle their debts in rupiah
(equivalent to the amount of the dollar debt service on the due
date) and pay into Bank Indonesia in favor of foreign banks. The
foreign banks could agree with Bank Indonesia not to take out the
dollar-equivalent amount immediately but to stretch the amount
over an eight-year period. This would reduce total debt service
for the country (equal dollar demands) to some $25.8 billion in
1998. When corporations are financially healthy again with the
help of some owners repatriating some foreign assets, then
economic growth could return, exports could flow again at higher
levels, the rupiah could strengthen to more reasonable levels,
local prices could drop, foreign currency loans could again
become available to good companies, foreigners would be willing
to invest in the Jakarta Stock Exchange, and the $25.8 billion
would be easily serviceable.

How can we organize this private sector half of the program?
President Soeharto has already appointed an excellent team under
the guidance of Dr. Radius Prawiro. Furthermore, a senior private
sector businessman, Tanri Abeng, was included in the new economic
team appointed last Thursday. What still seems to be missing is a
coordinating entity which could be set up jointly between foreign
banks and local Indonesian companies to help organize the
process. This company could be called PT Indonesian Credit
Clearing Corporation.

If a private sector program can be put in place, the IMF
program would have an excellent chance to succeed. Without the
former, the country's economic turnaround will take years of
hardship. The IMF expects their program to take two years to get
the Indonesian economy back on track. I believe that a private
sector program could turn the economy around in six months. Both
elements are needed, but implementing only half a program will
only slow down the process unnecessarily.

The writer is the Indonesian country manager for ABN-AMRO
Bank.