Have the markets gone mad?

By C.J. de Koning

JAKARTA (JP): Have markets gone mad on the rupiah? This is a valid question when a depreciation of 5 percent to 10 percent per day occurs. There are two ways to look at the markets. The first one is through the valuation of assets. For instance, how much is a building worth? This is a comparable to the balance-sheet methodology. The second one is through the foreign currency cash flow of a country comparable to the cash flow method.

On the asset valuation front, markets have clearly gone mad. Let us consider the market capitalization of the Jakarta Stock Exchange. In June 1997, its stock market value as expressed in U.S. dollars stood at US$100 billion. As of last Friday, the index has halved in value and the rupiah has dropped from Rp 2,400 to the dollar to Rp 5,200. Total valuation now is $23 billion. For $23 billion, all listed shares of all Indonesian listed companies together can be bought. This is the same value as buying 160 Boeing 747s. Ridiculously low valuations unless a major economic disaster is expected. The market has clearly gone mad.

Now, let us look at foreign currency cash flows for Indonesia. Indonesian private sector companies have arranged to borrow $65 billion in foreign currencies. The average maturity is 1.5 years, which means that the private sector repayment obligations are $3.6 billion per month and $43 billion in the coming year. Add to this the interest to be paid of nearly $6 billion per year, and one can easily understand that a $49 billion payment obligation creates an immense hurdle. The $65 billion represents the same value as 450 Boeing 747s.

Now think of an airline company or many smaller airlines together with this fleet. Could an airline repay $49 billion in one year out of its $65 billion investment? Of course not, it would already, in the first months, have to slow down operations as the cash flow would clearly be insufficient.

Planes would be grounded and soon, the whole airline would cease operations. The airline would have lots of assets, but no cash flow. The replacement value for the planes (the true value of the assets) would still be pretty close to $65 billion if a buyer could be found. If not, all asset values will rapidly disappear as a massive value destruction takes place.

Indonesia, just like the supposed airline, is currently going in exactly the same direction as the airline's cash flow example. It has great difficulty to generate the $49 billion needed to service its private sector debt. As the outlook to succeed looks poor, currency markets react with a vengeance and the rupiah's fall appears unstoppable with all its negative consequences on inflation, unemployment, etc.

In our opinion, the market has reacted rationally to the situation. The markets have not gone mad, however bitter the pill is for Indonesia. The country's private sector companies are moving from a going concern to a liquidation scenario with all the nasty side effects.

What to do is, of course, the million-dollar question.

Let us consider a few points. In the case of Indonesia, foreign banks are nearly the sole lenders of the $65 billion. Indonesian private sector companies are the borrowers. The problem of repaying $49 billion is a private sector problem. The IMF program, while providing the dollar backing, does not directly relate itself to the core of the current problems, that is, to the foreign currency lending-borrowing relationship of the Indonesian private sector companies and the foreign banks.

The indirect approach makes the IMF program less effective.

As stated, the Indonesian companies -- compare them to the airline -- will have difficulty in generating $49 billion in 1998. But individually, some companies are better run than others and will have less difficulty. Not all companies are the same, nor should they be treated the same.

Our suggestion is to split a possible solution into two elements. One, is the macroeconomic question on what Indonesia as a country can afford to pay in dollars in debt service, and two, is the microeconomic question on what individual companies generate in dollar cash flow over time. How much can they pay and when.

The solution to the macroeconomic question is to realize that the average maturity schedule of all Indonesian private sector debts together is ridiculously short and cannot possibly be afforded by the Indonesian airline. By insisting on this, the airline will quickly grind to a complete standstill and a huge asset-value destruction will and is taking place.

Therefore, the foreign lenders need to agree that the Indonesian foreign currency cash flow can, like an operating airline, realistically afford to redeem its foreign currency debt over a period of say eight years. This is not a default situation, but a realization that a $65 billion investment does not generate $49 billion in foreign currency cash flow in year one.

On the micro side the Indonesian borrowers have agreed to the maturity terms of the lenders. They should not be let off the hook so easily. Their individual cash flow generating ability must have been close to the agreed repayment schedule, otherwise they borrowed unwisely. Therefore, with each foreign currency borrower, individual negotiations need to take place based on realistic cash flow projections for the company. It is our guess that 90 percent of the private sector external debt is taken up by 1,000 companies to 1,500 companies, probably even less.

The next question is: How to achieve the macro and micro objectives at the same time? What is needed is an institution in between foreign lenders and Indonesian private sector borrowers. This institution should be able to act in the macroeconomic interest of Indonesia together with the foreign lenders as well as act in the microeconomic interest of the foreign lenders and Indonesian private sector borrowers. One could call such an institution the Indonesian International Debt Clearing Institute (IDCI). The IDCI, as it acts on behalf of foreign lenders, should be run by foreign bankers.

The IDCI could agree with the foreign lenders that an eight- year repayment schedule would be rational in terms of Indonesian foreign currency cash flow.

The IDCI could, on behalf of the foreign lenders and together with them, agree on cash flow projections of each individual company and keep these companies and their owners to their obligations, often for very much shorter maturity periods than eight years.

The IDCI could work out with Bank Indonesia (BI) how the micro repayments and the macro international settlement can be combined. One solution is that IDCI receives from the borrowers their debt service payments in rupiah equivalent of the dollar price quoted by banks on the day of payments. IDCI transfers these rupiah to Bank Indonesia, for which it receives "accounting dollars".

Bank Indonesia should agree to buy the real dollars or arrange for them in the international capital markets prior to each maturity date of IDCI's commitment to the foreign lenders. Macroeconomically, BI then can spread the purchase of the actual dollars over an eight year period. A substantial part of the pressure on the rupiah exchange rate generated by the $49 billion cash flow payments will have gone, and the rupiah can find its value much more in line with asset values.

In order to strengthen the scheme, BI could consider that for the first four years, it would guarantee the dollar payments to the foreign lenders, in line with the macroeconomic cash flow projections. This means that in case the microeconomic collections run short of cash flow projections, BI becomes a risk partner with the foreign lenders in the collection process.

On the operational side, IDCI charges an administration fee to cover its costs. It should be seen as an "agent" institution for the foreign lenders, carrying out collections and renegotiations.

On a more permanent basis, IDCI should be the instrument that assists in managing private sector convertible currency cash flows, thereby avoiding currency crisis caused by a mismatch in private sector foreign currency borrowing obligations and macroeconomic cash flow's ability to pay.

The IDCI can be effective if it is given veto powers on new foreign currency loans. For instance companies (and their owners) who have rescheduled their international debt should not qualify for any further foreign currency loans until all their outstanding have been cleared. Other companies (and their owners) who do pay on time can arrange loans with foreign banks (or local banks) in foreign currency.

However, the IDCI veto power should apply to two elements of the planned facilities. Firstly on the size of the loan. These volumes need to be checked against the macroeconomic cash flow projections. Second, on the maturity schedule of the planned loan, again to be checked against the macroeconomic cash flow projections.

It is our view that IDCI can be very instrumental in making the "Indonesian airline" fly again rather than being grounded.

Of course a single institution cannot solve all problems. To improve foreign currency cash flow (exports), a positive action plan could be organized whereby all interested parties -- private sector companies and the relevant government entities -- work together to promote exports and eliminate unnecessary domestic barriers.

Furthermore, the process to improve the local banking sector will also assist in creating more foreign currency cash flow.

In conclusion, the driving force behind the current rupiah volatility is the cash flow dominated demand for dollars from the private sector. This demand is not based on a realistic macroeconomic repayment schedule, but rather on microeconomically agreed schedules.

What the IDCI can do is bring the macro and micro situations much closer in line, thereby avoid a massive destruction of asset values. Once accepted by all parties, the rupiah's outlook should be more optimistic and closer to its asset value rather than based on short-term cash flow considerations. We believe in Indonesia's ability to keep flying.

The writer is country manager Indonesia for ABN-AMRO Bank.