RI's international stakeholders

By C.J. de Koning

JAKARTA (JP): When monetary crises are spreading like an Asian flu, and effecting countries all over the world, it may be pertinent to study better cross border capital flows and financial risk taking.

Take Indonesia for example. As at the end of June 1997, foreign fund providers had made available some US$210 billion, which consisted of $138 billion in loans to the government, banks and the company sector.

Some $50 billion in share purchases on the Jakarta Stock Exchange and some $20 billion in direct equity investments in companies. By comparison, the total assets of the local banking sector amounted to about $175 billion by the end of June. The rupiah stood at Rp 2,450 to the U.S. dollar.

The foreign funds were used by the domestic owner stakeholders to build factories, chemical plants, coal mines, ports, bridges, power stations, offices, hotels and many other assets. Sometimes working capital was also provided, mostly to finance international trade.

One can easily draw the conclusion that Indonesia's economic enterprise was funded to a large extent by Indonesia's international stakeholders.

Such foreign stakeholders provide U.S. dollars and, over time, expect U.S. dollars in return, not rupiah.

There are two major risks that such foreign stakeholders experience as cross-border fund providers. One is the risk of a strong rupiah depreciation and the other is that the local counterparties -- government, banks, companies -- weaken substantially as expressed in U.S. dollars.

Everyone knows that the rupiah has dropped from Rp 2.450 to some Rp 12,000 currently. But does everyone understand how it happened and why ?

On the Indonesian side a number of initiatives were undertaken, which had never been tried before. Firstly in August last year the government introduced a free floating exchange rate system rather than the previous practice of devaluation and exchange rate stability at the new rate.

Secondly 16 banks were closed simultaneously on Nov. 1, 1997, again an experiment never attempted before. On the foreign side Thailand's monetary crisis made all foreign investors and banks more careful in keeping or expanding Indonesian financial risks. This, plus the political uncertainty developing in this country, turned financial flows into a strong financial Molotov cocktail.

The real explosion occurred in early January 1998 when the bottom fell out of the rupiah, it peaked at Rp 17,000 to the U.S. dollar. This was not the result of the Indonesian export sector suddenly becoming uncompetitive. It was solely due to foreigners (and some locals) pulling the money they had at stake in Indonesia out so rapidly.

Such flows are a self-strengthening process, more depreciation, means more withdrawals. One example is international trade finance. At the end of October 1997 foreign banks had some $14 billion in trade finance outstanding to local banks.

By the end of April 1998 this had been reduced to $5 billion. Each trade transaction is self-liquidating but the need for trade finance is permanent. Perhaps this reduction had something to do with the closure of the 16 banks, with the depreciation process and with the lack of transparency of the local banks?

Rupiah depreciation -- of the scale experienced -- also wipes out the equity positions of many companies and banks that have borrowed in foreign currency and not covered the currency risk.

Also the cash-flow position of the government with a rupiah tax income and foreign currency obligations is strongly affected. The consequences are serious: increasing unemployment and severe poverty, high inflation, especially food prices, and substantial government deficits to mention just a few.

Such foreign currency capital outflows cause a financial drought. There is no longer sufficient U.S. dollar liquidity in the system.

Malaysia has reacted to such undesirable capital outflows by building a dike around the ringgit and keeping the foreigners out of the ringgit currency and local stock market.

Money can be compared to water. Money like water makes things grow. Too much water causes floods, which are harmful and too little water causes droughts which are also harmful.

In my view to grow the economy rapidly in Indonesia, water (money) from outside the country can be effective, as long as it is not too much or too little.

Currently a foreign financial drought is occurring, caused by the excessive depreciation of the rupiah. Many foreigners have been pumping foreign currency out of the country. During the last two months the process has been reversed somewhat.

Many local companies, banks and government entities are in financial trouble, also caused by the financial drought and the excessive depreciation of the rupiah. Only the export sector is surviving and only those companies that still have sufficient working capital.

Turning the economic tide around can be viewed in the same way as turning the flow of water around. Pumping stations have to be set up in Indonesia to pump water (money) from outside the country back into the Indonesian economy, again as quickly as possible.

Currently the strategy is to use a high interest rate policy in rupiah to attract foreign funds. This policy has three drawbacks. For the foreign fund providers this policy deteriorates the local company and bank equity positions even further, making it unlikely that new foreign money will be lent to, or shares bought from, local banks and companies.

Secondly the foreign fund providers in buying rupiah take three risks, a currency, an interest rate and a local counterparty risk (the borrower). If the borrower risk is good, like Bank Indonesia, then the current interest gain per month of some 6 percent may easily be lost in a day on currency volatility. Only the currency speculators are likely to participate.

Thirdly a high rupiah interest rate regime also stifles the real sector domestic economy, which was already hard hit by the foreign currency drought. Furthermore it does not reduce the local inflation level as this was caused by the difference in world and local prices (i.e. the exchange rate effect) rather than by cost-push factors originating from the local economy.

Finally the high interest regime takes funds out of the local real sector and into the financial sector as it is unlikely that one can make a 71 percent return per annum on any economic activity other than short-term promissory notes (SBIs).

Under these circumstances, how can the best pumping station in the country -- Bank Indonesia -- work? To start with, it could issue short term U.S. dollar SBI's. Of course at a premium interest rate in order to attract the funds. One may think of 8 percent over Libor, as this is what state-owned banks pay for one months U.S. dollar deposits.

Those funds can be used to strengthen BI's foreign exchange reserves, to replace the expensive rupiah funding for IBRA's non performing assets with cheaper U.S. dollar funding and last but not least to help fund the sound local banks with U.S. dollar funds for international trade finance.

Such pumping coupled with ceilings on future external debt levels will jump start Indonesia's economic engine again. Local interest rates can be gradually reduced. The rupiah is likely to strengthen to some Rp 6,000 or even Rp 5,000 which is the level it reached as recently as December last year.

The writer is Country Manager Indonesia of ABN AMRO Bank. This article has been written in a private capacity.

Window: Money can be compared to water. Money like water makes things grow. Too much water causes floods, which are harmful and too little water causes droughts which are also harmful.