Cleaning up banking system is panacea to ailing economy

The following article is based on an interview with Dr. Rudiger Dornbusch of the Massachusetts Institute of Technology. The renowned international economist was in Jakarta last week at the invitation of the Prasetya Mulya School of Management.

Question: Economic turmoil hit with a domino effect in Asia, seemingly without meaningful warnings from experts. Why is this so?

Answer: I don't think an expert is going to be a hundred or even 80 percent correct. A lot of people drive drunk it doesn't mean that they all have an accident and it's also true that not everything that is a little bit risky must fail.

I think everybody was surprised by the extent of the crisis, which can in hindsight be explained, but it would have been extraordinarily difficult to predict. At the center of it is a banking crisis. Did we know that banks are just as vulnerable as they turned out to be? Of course not.

Did we believe that one country after the other would go down, and that therefore there is always the extra risk that you won't get turn around, surely not. I don't think the experts were very good on this one, just as they weren't with the Mexico crisis or on all of Latin America. Most banking crises are not predicted by experts, they happen and then we explain them afterwards.

Q: You mentioned in your talks the other day that the banking crisis in the region was an economic textbook case?

A: Well, in hindsight they are textbook cases when we can say these are the things that went wrong, and because they got to be really big, I could do an analysis just as, say, in a hospital they do a postmortem and say this man died of poison. I can do the same with this crisis, yes, it has all the classic ingredients.

Q: What do you mean by classic ingredients?

A: I mean that we have real estate, foreign exchange, lending on stocks, the classic ingredients for bankruptcy, but we also have, of course, the extra -- the innocent bystanders get hit. We have some survivors, like Hong Kong, so it is in that sense classic. It is not a new mechanism that we have seen, it is rather exactly the same, but which nobody suspected was in place here.

Q: You said Hong Kong has survived. How does it differ to other economies?

A: Hong Kong has a far stronger institution that protects its monetary system. And it has a far better banking system. If you like, Hong Kong has none of the corruption that characterizes, say, Thailand, and politics are very far away from money and banks. That's why Hong Kong is still there, unlike Thailand, where politics, money and banks are all the same.

Q: If the "classic elements" are there, what will the treatment be?

A: The treatment is to clean up the financial system, to learn to be more cautious with credit, to avoid inflation and in time life will be back to normal, but like after any accident it takes a while to normalize things.

Q: Do you think the IMF package prescribed for this region's economies will do?

A: The IMF package will help only if in fact the government implements it. If not, I think the crisis will deepen, the recovery will take more time and the vulnerability will continue to be there.

I think a lot of it is a recovery of confidence by the rest of the world, and also for Indonesians in their own system, and that will mean more transparency, understanding that in fact the dead banks are gone and that the remaining banks are good banks and well supervised. The government needs to do that even if it is politically uncomfortable.

Q: Supposing the Indonesian government fails to implement the IMF package, will there still be a chance for recovery?

A: Well, I think it is an open question. The longer the government waits, the longer it takes for normal credits to be restored and for interest rates to fall. It is a misconception to believe that not looking at the banks is the easiest way to get interest rates down. It's the opposite. It's also true that the longer the government waits, the greater the risk that the international rating agencies will rate down Indonesia, so giving the country a higher cost of capital and therefore a much poorer growth performance.

Q: If the government succeeds in implementing the IMF package what will happen?

A: I think 1998 will be a bad year and in 1999 normality will come back. If as the result of this crisis people have learned to drive more carefully in the area of finance and credit then there is progress of course, but I don't think that will translate into higher growth like you had before.

I think that the region has a problem and that any single country can do a bit better, but not a lot better. I would think two-thirds the growth you had before is probably the best you will do.

Q: So, it will never come back to what the people called the "Asian miracle"?

A: I think the Asian miracle is mostly China now and perhaps less here. The growth rate will be high simply because the country saves a lot and population growth is still high, but the miracle part I think is a bit off.

The miracle part is really the past few years where you had a bit too much boom and a bit much prosperity and you borrowed the money to create the impression that you were really rich. That I think is the excess that now needs to be paid for.

Q: So, in a way what Paul Krugman said was correct...

A: Well, he really talked about the fact that so much of the growth reflects savings rather than productivity growth. What we have seen in the last three years is that if you borrow a lot of money you can really look good until you have to pay, which is now.

Q: Living beyond one's means...

A: Very much beyond your means and using it to put up big buildings and for a lot of consumption which really adds very little to the country's economic infrastructure.

Q: You said that the miracle is now in China, but then Japan and South Korea have joined the club of turmoil contagion, will this development not affect China?

A: Well, I think that is the open question now, whether China can isolate itself. I think that China understands the risk well. They do have a very bad banking system, but they have really not engaged in external borrowing and they have far more restrictions on capital flow, so I think in this environment they are better protected. So I would think China will make it.

Q: The fact that the Hong Kong dollar is still pegged to the U.S. dollar, do you think Hong Kong can survive the turmoil?

A: No question about it, still the stake is very high for Hong Kong not to devalue and I would be surprised if they did...

Q: Despite its falling stock market...

A: Well, stock markets have fallen in a lot of countries and they survive the falls. I think the institutions to protect stock markets are very strong, but the devaluation will make things worse because of the loans being in dollars, resulting in instant bankruptcy.

Q: What do you think of the possibility of Japan's economic recovery after one of its securities companies went bust?

A: I am skeptical that Japanese policy makers really understand the extent of their problem and how to respond to it and if they make the wrong decisions, who is going to tell them and who will they listen to?

If they don't act until it's too late then of course we will end up with a big Asian crisis as a result. All the appearances are that Japan does not understand that they are on the verge of a really serious problem, for themselves and for the region and for the world economy. The policy makers in Japan are really quite ignorant.

Q: How do you define a big Asian crisis?

A: I think part of the story is that every country hopes to get out of the problem with exports. If Japan also goes down then your exports will not go to Japan. They will all go to the United States where there is limited enthusiasm for an enormous increase in imports, so we will surely get questions about free trade and when that question arrives, who will lend to Indonesia if there is a uncertainty about your ability to export.

So we get big questions about the system. If Japan were growing then the pressure on the U.S. would be less critical, so Japan is very critical to the equation and has, from its size, a real ability to pull all of Asia down.

Q: What will happen if Japan fails to pull itself out of the crisis?

A: Oh, then I think you have the great depression. Exactly what the Western world had in 1930s: big policy mistakes, everybody trying to export, nobody wanting the exports and the system goes down.

Q: So it could happen here...

A: Of course it could happen. With the current course of Japanese policy it's going to happen. So it's a really big risk.

Q: So you don't rule out the possibility of an economic depression across Asia...

A: No, not at all. If Japan does not turn, it will happen.

Q: When will indications of a depression surface?

A: Oh, well, next year. If Japan goes into recession next year you have it. It will be the first round of a whole regional problem, it is going to go round and around. Currency will go down, stocks will go down, confidence will go down.

Q: Even if Indonesia managed to implement the IMF package correctly?

A: You implement the package right but if you can't export, you're not going to grow, right? And if your market disappears, what are going to do?

Q: So there are two risks involved, one domestic, the other Japan...

A: Yes, and Japan is the bigger risk. Any country with a prosperous world economy just has to do the right thing. But if the world economy turns on you, whatever you do isn't enough. And I think that's the risk with Japan.

Q: How high is the possibility of Japan answering its challenges in the wrong way?

A: One would think that they could see it and say this is going to be a problem, but instead they are having conferences about the new IMF, which is a totally stupid thing to discuss at this stage.

Q: Could you translate this possibility into percentage?

A: Well, I don't know. Fifty-fifty...?

Q: The attempt to make another IMF is stupid thing...

A: We have one. Why do we need another one? Is the IMF somehow not generous enough? Everybody has gotten a bailout package, right? So, it can't be that they can't respond to a crisis. Japan first said they are too tough. If they are not tough, things get worse, right? It's a very, very silly discussion and the whole issue should be how to get the region back to growth. Without Japan, it's just not going to happen.

Q: How do you assess Indonesia's performance in implementing the IMF package?

A: I think there are genuine questions about the extent to which the government is willing to look at the banking system and to be very hard nosed in opening the books to apply supervision to clean up the banks. I think that is in question, and as long as it is in question I think the credit climate is going to be unfavorable.

Q: I am sure you learned that the government has granted a bank owner whose bank had just been liquidated a new bank...

A: Yes, that's the kind of thing that surprises you, right? If a new bank comes and the owner pays the deposit for the assets out of his pocket, then why did the bank go bankrupt? So, miracles happen, right? When that kind of thing happens it leaves the impression that it is a very, very deeply corrupt system, which is then not a place foreign investors want to go because someone is going to pay for it and they don't want to be them. I think it is a very difficult situation.

I think one has to ask, does the President know about what's going on? Perhaps he has no idea what is going on. Perhaps he doesn't understand how critical the cleanup of the banking system is for a return to normalcy and as a result these things are allowed to happen.

Q: You said the cleanup of the banking system is very important...

A: Oh, yes, the banking system is the nervous system of an economy. And if you make a botch of it, it is not going to work. It is totally central.

Q: And what are second and third in importance?

A: Oh, the rest people do by themselves, right?. The banking system is a very, very important systemic issue. It's your connection to the international capital market. It's the country's risk rating. It's the question of whether people give money here or abroad. Look at the Japanese. They put their money in American banks because they don't believe in Japanese banks, right? Small businesses in Japan don't get credit anymore because the banks are bankrupt. So it's a totally central issue for the functioning of a country. It's not a place you should allow a lot of politics and a lot of tricks. (hbk)