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.