No easy way out of RI's crisis

No easy way out of RI's crisis

By Bambang Subianto

The following is an excerpt from a paper presented at the
National Issues Forum put on by the Brookings Institute and the
Harvard Institute for International Development in Washington
D.C. on Oct. 2. This is the first of two articles.

WASHINGTON: In looking at Asia's economic and political
developments, one can truly say: "What a difference a year can
make!"

Just a year ago, the World Bank and the International Monetary
Fund seemed to assume in their annual meeting that Asia's
economic crisis would be speedily resolved and was unlikely to
spread much beyond the immediate group of affected countries.

Today such optimism would be highly misplaced. It is becoming
increasingly clear that we are in the midst of a serious downturn
that shows signs of spreading well beyond Asia.

Even (U.S. Federal Reserve Commission) chairman Greenspan has
been forced to take note of the spreading impact of the Asian
economic crisis. He said last week (at the end of September) that
"we have to bring the existing instabilities to a level of
stability reasonably shortly, to prevent the contagion from
really spilling over."

In reviewing the events of the last year, perhaps what is most
worrisome is the fact that the crisis shows few signs of abating
despite strong policy measures adopted by the affected economies
and significant financial assistance provided by multilateral
agencies and bilateral donors.

There is, I believe, a growing consensus that the weaknesses
in our banking system allowed the exogenous shocks to our
economies to become magnified and spread.

The story, while complex in detail, is painfully simple in its
broad outline. Essentially our financial institutions, as well as
those of other Asian economies, encouraged the funding of risky
and, in the end, unprofitable ventures.

Such an outcome was probably inevitable in a financial system
where state-owned banks play a significant role and, perhaps even
more important, where interference is likely to be pervasive.

Not only were funds directed to projects that could not
compete in the global marketplace when input and outputs were
priced appropriately, but market participants felt that reliance
on government-directed loans gave such projects an implied
guarantee.

Compounding our difficulties, there was a close link between
various banks and some of the countries large business groups, or
"conglomerates".

Such links further reduced the likelihood that loan requests
would be objectively evaluated. Loans were rarely subject to
careful financial or economic analysis. Such analysis was
handicapped by the absence of disclosure requirements.

In such a climate, it was clearly impossible for even the most
well-intentioned analyst to make a reasonable risk estimate.
Compounding these problems was a lack of prudence and discipline
by bank regulators in reporting some of the most flagrant
violations of our banking laws.

For example, I recently learned that one of the banks the
government was forced to take over had lent close to 80 percent
of its portfolio to affiliated companies in the same business
group -- a clear violation of our banking laws which place a
limit on intra-group lending equal to 20 percent of the owner's
equity.

One obvious result of operating under a dysfunctional
financial system is that banks fail in their most basic function
to serve as efficient intermediaries to effectively channel
savings to their most productive use. When savers, whether
domestic or foreign, have no real means of evaluating risks, it
is inevitable that the true cost of capital will be understated
with a consequent overstatement of the returns on investment. As
a result, scarce funds will be allocated to low-return, high-risk
activities.

We should also recognize that when neither investors nor
lenders expect to bear the full cost of any failure, they lower
their guard against risky investments. This is the often referred
to issue of "moral hazard", a situation in which, in the presence
of a perceived implicit or explicit guarantee, there is little
incentive to avoid risky behavior. It is true that the government
never extended any explicit guarantees against bank or corporate
failures. Yet it is also true that the involvement of well-
connected parties in many of our economic activities generated a
feeling that such investments would not be allowed to fail.

Our foreign exchange regime also encouraged risky behavior.
Until August of last year, Indonesia maintained a "crawling band"
exchange rate system. The system held exchange rate movements
within a relatively narrow range.

Although Bank Indonesia began to widen the band, hoping to
jolt borrowers to recognize that they needed to hedge exchange
rate risks, the band was widened in small steps that clearly
failed to send the intended message.

Because of our success in containing inflation and in holding
our exchange rate relatively constant in real terms, borrowers
perceived that the expected loss from any likely currency
depreciation was less than the cost of currency hedging.

And for many years this assumption proved to be correct. But
the incorrect pricing of foreign capital created vulnerability
for firms with substantial foreign exchange exposure. When we
were forced to abandon our managed float system, the rupiah's
depreciation created unmanageable debt burdens that effectively
bankrupted a substantial portion of our corporations.

Dr. Bambang Subianto is minister of finance.