Counting the costs of risks in crisis
By C.J. de Koning
LONDON (JP): Everyone in the world is exposed to risks: individual risks, like health and fire, and collective risks. Collective risks are contained in the political situation, the social environment, the climate, the status of the economy, the Jakarta Stock Exchange index and the funding situation of Indonesia Inc.
What price (or costs) should we put on political risk? Economists and bankers like to put a money value on risks. How could one measure, in money terms, such diverse political elements as personal safety and security, law and order including the level or the lack of corruption, collusion and nepotism, freedom of expression, freedom of religious beliefs and the freedom to establish political parties?
Economists also find it difficult to put a money value on social risks. Un-and underemployment, people sliding into poverty, declining education and healthcare levels are not easily expressed in monetary terms. Lost opportunities in output and income, lower standards of education and healthcare are like "what if" questions, more theoretical than practical.
Economists and bankers can better assess economic risks, which are how assets (land, labor, stocks and capital goods) are used efficiently and effectively in creating output and employment. Financial risks are the reflection of all risk factors together. These are the risks that bankers are most familiar with. The financial risk price is reflected in the cost of funds, which is similar to the costs of borrowing money.
An example of a financial risk price is the effective cost of U.S. dollar borrowings for Indonesian entities -- the government, the banks and the privately owned companies -- over the period July 1, 1997 till June 30, 1998. The actual price as expressed in rupiah was in excess of 330 percent over the one year period. This single price, 330 percent per annum, shows to what extent the price of financial risks can change in the short run. In the year up until June 30, 1997 the financial risk price for U.S. dollars as expressed in rupiah had been around 13 percent to 14 percent per annum.
Several observations can be made regarding this financial risk price of 330 percent.
Firstly, this price is clearly a relevant price as currently some 65 percent of all Indonesian borrowings are in U.S. dollars. The risk price for the remaining 35 percent of borrowings, all in rupiah, went up to over 70 percent per annum over the same period.
Secondly, the absolute level of 330 percent shows a number of facts:
* A rupiah debt equivalent of Rp 1 million at June 30, 1997 increased to Rp 3.3 million debt as per the end of June 1998.
* No government, bank or company can hope to earn revenues of 330 percent in one year on capital invested.
* The price of the financial risks no longer reflects the underlying asset values, and their ability to create output, employment and cash-flow
* The existing risk providers -- banks and investors -- did not gain anything from this price increase, rather the reverse
* The risk takers -- the Indonesian government, local banks and companies -- did not gain anything from this price increase either, again rather the reverse
* The potential risk providers -- new funds and equity -- did not come forward as the counterparty risks on Indonesian entities did not entice newcomers to come in. The risk of losing the principal sum far outstripped the uncertain potential of gaining.
* The consequences in social terms of this increase in the financial risk price were dramatic, with soaring unemployment levels and rapidly increasing levels of poverty, school drop-outs and deteriorating general healthcare. One may draw one's own conclusions on whether this social upheaval also increased the level of political instability.
The overall conclusion based on these facts is that in Indonesia, and most likely in other countries as well, the relationship between the price of financial risks and the supply and demand for funds is unlike that which all existing economic theories predict.
It is also different from what the IMF advised Indonesia. The conclusion can be drawn that: When the price of financial risks goes up in Indonesia, both supply and demand for funds come down. The invisible hand of Adam Smith leading to a new equilibrium situation clearly does not work in this particular instance. Rather the opposite occurred. The increase in U.S. dollar related interest rates caused both the supply and demand for funds to drop and move away from equilibrium.
Why and how can interest rate increases lead to both lower supply and lower demand for funds?
In Indonesia some 200 foreign banks were active when the crisis started, serving some 1,800 companies, banks and government customers. On average each bank had some US$700 million in loans outstanding, of course with great variations in amount between banks and great variations in client base.
Also for many banks counterguarantees were in place for part of the portfolio, either from export credit agencies or foreign based companies. With such a level of exposure the key to risk taking is contained in maintaining the value of the existing portfolio before any thought is given to expansion.
When the risks go up on the existing portfolio this does not mean that the lenders get any better price for their risks. Withdrawal from risks, or attempts to do so, becomes the obvious way out. Such withdrawals increase the risks for all other lenders.
In conclusion the benefit of the interest rate increase does not reach the existing lenders. With financial risks increased and no effective change in rewards the supply of funds comes down.
On the borrowers side the cost increases were very real. For the U.S. dollar exposure the exchange rate effect explains the horrendous increase in effective interest rates.
Secondly the short average loan maturities increased the pressure on current cash-flows even further. For the rupiah borrowings the interest rate cost increases were also very real. In conclusion risks did go up extremely rapidly over the year to June 1998, wiping out equity levels of many companies and banks and worsening the financial position of the government dramatically.
Under these circumstances risks on companies prevented any new lending, but rather encouraged reduction of existing lending levels. A case in point is international trade finance for Indonesian companies. In other words increased financial risks and substantially higher costs of borrowing led to a lower demand for funds.
This is exactly the scenario in which increased interest rates lead to both lower supply and lower demand of funds. A scenario which moves the economy away from its economic growth path.
It is the scenario of the widening gap between the economic and financial lifespan of assets, which was explained in a previous article in The Jakarta Post (Dec. 7 and 8).
It is also the scenario which, more than any other factor, caused the Indonesian banking crisis. The same scenario creates the increased unemployment levels, the move towards greater poverty levels, lower education and healthcare standards in other words higher social risk levels.
The price of financial risks is a key factor in the financial, economic and social well being of Indonesia. Considering economic policies without understanding the effects on supply and demand for funds is like sailing without a compass in hurricane force winds. Regretfully it seems exactly what the IMF advised Indonesia to do.
Any economic adjustment mechanism needs first and foremost an acceptance of the above stated evidence. Secondly, once accepted, both the rupiah interest rate level could be brought down rapidly to some 20 percent per annum and the effective U.S. dollar interest rate could be brought down by an appreciation of the rupiah -- the U.S. dollar rate to Rp 5,000 to 6,000 to one U.S. dollar.
The latter can easily be reached via Bank Indonesia issuing short-term promissory notes in U.S. dollars at increased interest rates.
Thirdly it should be accepted that a majority of the 1,800 companies involved have become uncreditworthy according to all acceptable credit standards. A major recapitalisation drive will be needed, which will probably require foreign funding again.
Last but not least the sad fact and the hard reality is that many Indonesian owners have lost their equity values in their companies. The government may need to work out innovative financing structures in order to prevent the remaining assets all going to foreign entities.
The writer is former Country Manager ABN AMRO Bank Indonesia, currently with ABN AMRO London. The article was written in a private capacity.