Currency crisis triggered by inefficient investment

Currency crisis triggered by inefficient investment

By Vincent Lingga

HONG KONG (JP): The thousands of economists, monetary pundits
and securities analysts who gathered here for the annual meeting
last week of the International Monetary Fund and World Bank, and
the dozens of seminars and panel discussions held before the
meeting, came up with almost the same diagnosis of the disease
which led to the recent currency crisis in Southeast Asia.

They cited a weak financial system, especially the banking
industry, too heavy a dependence on foreign capital, notably
portfolio funds, widening current account deficit and a too-rigid
exchange rate regime.

The solution obviously focuses on a cure for these ills, in
addition to the standard advice on sound macroeconomic policy.

The same solution has also been central in the policy
recommendations provided by the various reports issued by the IMF
and the World Bank, as well as its affiliate institutions.

Several economists went deeper, by analyzing the capital
productivity and profitability, or in the context of what
Indonesia's most senior economist Sumitro Djojohadikusumo usually
calls the incremental capital output ratio (ICOR).

Daniel Franklin, the editorial director of the Economic
Intelligence Unit -- the think tank of the Economist group in
London -- questioned the trumpeted praise of the high domestic
savings rate in and large capital flows to the major emerging
markets in Southeast Asia.

"It is the quality and not the quantity of investment that
should attract analysts' attention," Franklin said in a seminar
that discussed the myths of emerging markets and their hidden
risks.

David Roche, president of Independent Strategy research
institution, said in the South China Morning Post daily that it
was an anomaly that the major economies in Southeast Asia which
have massive domestic savings rates of up to 35 percent, still
used foreign capital of up to 6 percent and 9 percent of their
gross domestic product.

Roche raised a puzzling question as to why the steadily big
imports of capital goods by the Southeast Asian economic tigers
have no longer been able to generate sustainable growth and
steady expansion of exports.

His conclusion was that in the major economies in Southeast
Asia, the superior capital productivity and profitability -- the
equation of cheap labor combined with new machinery -- does not
hold any more.

Roche estimated that in the past five years, it took US$4.60
of capital investment in Indonesia and Malaysia to produce just
$1 of output (an ICOR of 4-to-6).

Roche's estimate is not much different from the incremental
capital output ratio made last year by Sumitro for Indonesia.

Sumitro has repeatedly called for more concerted efforts to
improve the efficiency and productivity of investment in
Indonesia, to reduce the country's dependence on foreign capital
(official and private borrowings and private investments).

In Thailand and the Philippines, according to Roche's study,
the ICOR was even higher. It required $5.50 of capital to
generate $1 of output.

Hence, the key problem, according to Roche, is that the
productivity of investment in Southeast or East Asia in general
has been worsening.

He estimated that quite a portion of the large domestic
savings in Southeast Asia had ended up in companies which
undertake real estate and property development financing.

John Greenwood, chief economist at Chancellor LGT Asset
Management, came to the same conclusion, saying that since 1993,
the excessively high credit growth in Southeast Asian countries
had partly been wasted through inefficient investment.

Greenwood noted the annual credit growth in the ASEAN four
(Indonesia, Malaysia, Thailand and the Philippines) rose from 14
percent in 1993 to more than 30 percent in 1995.

He said even the dynamic economies of these countries could
not have absorbed such a massive credit expansion without
overheating: strong domestic demand growth, widening current
account deficit and over-extended markets for equity and real
estate.

So, their key advice is for Southeast Asian countries to
increase the efficiency and productivity of their investment in
order to narrow the gap between domestic savings and investment,
which has been mainly responsible for their large current account
deficit.

Further down the road, less dependence on foreign capital
would reduce their vulnerability to currency volatility. An added
benefit is that more productive capital investment would reduce
the inflationary risk of high growth.

American financier George Soros, who also addressed one of the
seminars here, voiced similar advice.

Soros, who has made tons of money from the international
currency market, said financial markets are inherently unstable
and international financial markets are even more so because
capital flows are notorious for their boom-bust pattern.

"So, the best way to achieve (currency) stability is to
mobilize domestic savings for domestic capital formation in an
efficient fashion," Soros said.

Greenwood cited the promotion of many government-orchestrated
projects of dubious commercial viability in Malaysia and
Indonesia as examples of grossly inefficient investment.

Franklin noted that in several Southeast Asian countries where
domestic savings have been abundant and capital flows
significant, the temptation for politicians to funnel investment
into pet, large projects and even to pick industrial winners is
great.

The bottom line of these economists' analytical observations
is that governments are making the mistake of plowing domestic
savings into prestige projects when what is needed is increased
investment in education to overcome the shortage of skills badly
needed to develop industries of higher value-added products.

Sadly, though, the strong capital inflows from overseas so far
had created an atmosphere of over-confidence, which resulted in
excess investment in a variety of sectors, which now have to be
cut back after the currency turmoil.