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.