Have the markets gone mad?

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.