Liquidity matters in the end

By Eddy Soeparno

JAKARTA (JP): It is now clear that relying on foreign money has its costs. The Asian miracle, characterized by the economic boom in the region over the past two decades was undoubtedly nurtured by unprecedented flows of capital.

Even U.S. Federal Reserve chairman Alan Greenspan confessed in retrospect that "it is clear that more investment monies flowed into these economies than could be profitably employed at reasonable risk".

In addition, Massachusetts Institute of Technology's Paul Krugman agreed that "enormous inflows of capital allowed Indonesia and Asian countries to spend far more than their incomes".

Unfortunately, much of that money was in the form of short term investments, and could flee as quickly as it arrived. Right up until the eve of the crisis, Asian economies could do no wrong, in the eyes of investors and creditors.

It was an absolute win-win situation for investment houses and banks, especially since opportunities seemed endless and continued arising almost every day.

Look at Asia at that time: Inflation was under control, it had none of the excessive budgets that Latin American countries had, labor costs were considerably low and savings rates were at high levels. As such, money kept pouring in.

In 1996 alone, foreign banks lent the countries currently in crisis more than US$100 billion, while nonbank investors poured in tens of billions more. And as soon as speculative attacks against their currencies commenced in the second half of 1997, those same banks called in more than $50 billion worth of loans.

Soon afterwards, the whole house of cards fell apart and the Asian miracle became a major debacle. Investors, foreign and domestic, rushed to the exit doors, leaving governments powerless to defend the currency as well as the economy.

In trying to hold back the stampede of runaway investors, Indonesia continually restated that its economic fundamentals were strong and different from those of Thailand and Korea.

These supposedly encouraging remarks apparently did not stop the capital outflow, until the government realized that it was not fundamentals that investors were so concerned about, but market confidence.

Therefore in its quest to bring market confidence back to the country (and at the behest of the International Monetary Fund of course), the government responded by raising interest rates to 30, 50 and 70 percent to stabilize the currency, not realizing that its private sector was up to its neck in foreign debt.

This in turn pushed even the soundest corporations into bankruptcy, increasing the bank's nonperforming loan portfolios, provoking devastating bank runs and finally plunging the economy into deep recession.

It is only modest to say that many of the now debt ridden companies in Indonesia, were previously lectured by aggressive creditors that "borrowing money is a good thing to do and that the more loans a creditor is willing to make is an indication of his confidence in ones business".

In the beginning, some twenty years ago, most business families were opposed to the idea of leveraging themselves with bank loans, as it was viewed as costly, thus cutting a portion of their bottom line earnings.

In most cases, businessmen could also not accept the idea of "working for the bank", by continuously having to service debt.

It was simply against their entrepreneurial principles.

Moreover, most business people were liquid during those days, as the attitude of not borrowing money discouraged them from going into any form of business they were not capable of self- funding.

But soon after the concepts and benefits of "using other peoples money" were familiarized in the seventies, Indonesian businesses started to look for bank financing whenever possible.

At the same time, government directed and sometimes guaranteed borrowing also encouraged Indonesian businesses to fund investments and expansions through either the debt or capital markets.

Thus its reliance on self financing slowly became of lesser importance, as the ability to source third party financing became more of a priority.

Approaching the nineties, most of Indonesia's new breed of conglomerates became familiar faces to a large and growing number of domestic and foreign banks eager to finance any new activities, knowing that the returns would be profitable.

And with more banks and investment houses struggling to obtain a thin slice of the cake, borrowers became not only more hungry for external financing but also more aggressive in entering new and frequently unknown business territories.

With the continuous flow of credit and investment, corporates grew to become business groups and business groups demanded more money, while conditions attached to financing became less stringent.

Slowly and almost unnoticeably, a shift in the entrepreneurial paradigm had occurred, as bank loans walked hand in hand with entrepreneurship in the development of corporate Indonesia.

And as almost endless amounts of money kept pouring into the private sector, businesses had practically very little incentive to maintain self liquidity to wholly finance its operations.

At times, internally generated cashflows were not even sufficient to cover basic operational needs, such as the purchase of raw materials. But as financiers stood eagerly at the sidelines waiting to extend more money, who needed self liquidity anyway? Even if one creditor was limited to increasing his exposure to one debtor, other creditors were already in the queue with ready-to-spend money in their pockets.

During the months preceding the crisis, Indonesia's corporate sector was floating in an ocean of debt. Businesses were highly dependent on bank loans and other external forms of financing, therefore the financing and refinancing markets became central to the continuation of ones business.

But who could ever predict a crisis of this magnitude, catching the banking and business sector totally by surprise?

As soon as the rupiah depreciated and borrowers debt levels increased by fourfold overnight, the much needed financing and refinancing markets disappeared, in line the reluctance of financial institutions to make new loans or even roll existing ones over.

As the self-inflicting panic waves reached the boardrooms of the financiers head offices, orders to "pull the plug" on these companies followed soon afterwards. But with loans primarily tied up in fixed assets, none of the borrowers could make good the payments when demanded.

Today, while loan restructuring becomes a daily routine between borrower and lender, almost no new lines of credit are being extended to the business sector. The result is predictable: with hardly any internally generated liquidity in place, the business sector lacks the essential "fuel" to run its operations.

And until liquidity flows back into the real industry, the economy will remain dormant, leaving the banking sector totally defunct.

But certainly, even during these difficult times a handful of business entities are bound to pull through, especially those with low leverage and high liquidity.

These companies are viewed to be more vulnerable to market demand rather than credit supply, as they are more or less self sufficient in providing their internal needs for cash.

However with lower than ever consumer demand (except for maybe offshore demand), how much longer can say retailers, dairy producers and pharmaceutical producers sustain the pains of depressed demand? As Paul Krugman explains, even the soundest companies are at risk of being wiped out by the crisis.

However one thing remains certain, businesses with high internal liquidity and little reliance on bank financing are the ones who stand tall and are likely to survive as well as be the first to recover from the crisis.

These are also the ones that banks and other financiers will be targeting and insist on handing money to in the future, knowing that its management successfully made its way through the cirrhosis.

One thing they may choose to overlook is the fact that future unnecessary credit flows into these companies could make them vulnerable in facing the next crisis.

It is therefore important to remember that liquidity got these companies out of the crisis and will further serve the same purpose in similar conditions in the future. After all, having liquidity is what counts in most situations.

The writer is a corporate finance director of American Express Bank.