Risk reduction strategy needed

By C.J. de Koning

JAKARTA (JP): A world-wide discussion has started about the merits of global capitalism and of short-term capital flows, a subject especially urgent in view of the economic contagion spreading to many developing countries and now threatening the economies of developed countries.

The roles of the International Monetary Fund, World Bank and regional development banks are now being examined and questions are being raised whether these institutions are still up to the task of addressing the world's economic shortcomings.

Some experts analyze financial policies and their market impacts, like the affects of hedge funds in allegedly causing Malaysia to effectively force foreigners out of its currency and equity markets.

In my view, the discussion has so far focussed more on what is happening and what its effects are -- such as how short-term capital flows affect a currency and threaten a country's economic growth rate -- rather than focussing on the principal question of why all this is happening.

Indonesia, which has maintained a fully open currency system with full and free convertibility for over 30 years to its great economic benefit up until June last year, can serve as one of the best cases to look at in the world.

We could start by looking at when the crisis began in July last year. The month before, foreign stakeholders -- an appropriate term for any investor choosing to put money at stake, or at risk -- had approximately US$210 billion at risk in this country, $138 billion of which was in cross-border loans to the government, local banks and the private sector, while some $50 billion was invested in shares on the Jakarta Stock Exchange and $20 billion locked into direct equity stakes.

Local stakeholders, on the other hand, had $225 billion at risk, with the combined assets of all the country's local banks measuring $175 billion and a further $50 billion in listed share values on the Jakarta Stock Exchange. Furthermore, they owned a substantial, yet unknown, amount in all other equity values throughout the country.

At the time, the rupiah was being traded at 2,450 to the U.S. dollar.

In all, some $435 billion was at risk: at least $120 billion in equities and $315 billion in loans. Indonesia's annual output (GDP), however, was running at some $200 billion.

Other notable aspects of the economy include the fact that the government had run a balanced budget for 30 years, inflation had been averaging 7.5 percent per annum and exports were growing 12 percent per annum from a base of $56 billion. There was also no significant increases in wages or any excessive consumer demand. The country, however, did not concentrate on measuring or limiting external debt, not to mention its average maturity profile.

Why did Indonesia's monetary crisis occur and why has it been more tumultuous here than in any other Asian country?

Forecasts predict a decline in the country's economic growth of some 18 percent this year. The rupiah has lost more than 75 percent of its value since the crisis began compared to a 38 percent plunge in the Thai baht and the Korean won over the same period. In many ways, the Indonesian government had been more financially prudent than many of its neighbors since it did not run a budget deficit and did not have any domestic debt.

The answer lies in "the money value at risk factor". Capital flows are a symptom, not the cause -- much like a high temperature being the symptom of a flu, but we all know it is not the cause. Trying to cure Asia's monetary flu by fighting its "high temperature" can only relieve the symptom -- just like Malaysia is doing -- but puts the patient at even greater risk if the cause of the flu -- the virus -- is not understood.

Foreign and local investors all have a common goal when they put their money at risk: They want positive returns with the smallest degree of risk. The degree of risk acceptance varies, though the principle does not.

In the financial relationships between foreigners and domestic stakeholders, two main risks occur: the exchange rate risk, and the risk that the counterparty can no longer pay (counterparty risks).

The exchange rate risk is a factor in all cross-border transactions, whether in shares or in providing loans. Foreigners like to receive U.S. dollars in loan repayments, not rupiah.

The counterparty risk factor is intricately linked with exchange rates. Since most of Indonesia's sovereign and private financial obligations are in U.S. dollars and income is in rupiah, then any depreciation of the rupiah increases the risk factor for all outstanding cross-border money claims. Increased risks reduce any further appetite for risk taken by foreign investors and lenders. They tend to withdraw their money from the market -- it is a self-strengthening process, not one that corrects itself automatically.

One need only look around to see what the monetary crisis has done to the country's population, companies, banks and even the government.

If the risk factors are clear -- exchange rate risks and counterparty risks -- then one can further analyze the risk- taking process.

Two elements stand out in this process: market psychology and speed of change.

The speed of change in Indonesia can be seen over the period of late December last year to the third week in January when the rupiah tumbled from 5,200 to 17,000 against the U.S. dollar.

The fall had nothing to do with Indonesian exports being uncompetitive in the world market, but everything to do with capital flows. It was a typical example of "overshoot", with disastrous effects on exchange rate risks and counterparty risks.

Another example can be seen in October last year when foreign banks had some $14 billion in international trade finances locked into local Indonesian banks. By the end of April, however, this figure had been reduced to $5 billion, though trade financing needs are a permanent necessity.

The second element is market psychology. Every sane market participant tends to pull out their money when eying increased risk positions. Many also understand that collective mass withdrawals actually increase risks rather than reduce them. No country -- including Indonesia -- can withstand mass withdrawals, much like no bank can withstand a massive run on its deposits.

Managing a country is quite similar to managing a bank. Funds are entrusted -- in rupiah and in U.S. dollars -- and invested in/or lent to domestic asset holders. The management needs to ensure that credit risks are acceptable and that funds can be repaid when requested.

Finally, Indonesia suffered more than most countries for the simple reason that it has maintained a full and free currency convertibility policy for the past 30 years, including during the crisis. This policy encourages inflows, but also accommodates outflows if risks are deemed unacceptable. The solution is not to change the convertibility policy, but rather to address solutions to the risk factors.

Macroeconomic policies have to be checked against risk factors. For instance, in August last year Indonesia introduced a free floating exchange rate policy -- for the first time in 30 years. This experiment increased risks rather than reduced them, especially since the country is 50 percent funded by U.S. dollars. A return to the previously practiced managed floating policy would reduce risks.

High domestic interest rate policies also increase risks, especially counterparty risks. If U.S. dollar cash outflows caused the crisis -- however indirectly -- then the U.S. dollar risk price needs to be increased, not the domestic currency risk price.

In hindsight, the IMF's package for Indonesia -- though beneficial when viewed over the long run -- will not be able to reduce increased exchange rate risks and subsequent counterparty risks in time. The speed of change and the market psychology has been changing faster than the adjustments by the IMF.

A run on a country is like a run on a bank. If the cash withdrawals cannot be stopped soon, then all that will be left will be the bank buildings, the staff and a huge number of nonperforming assets. When liquidity goes, the bank goes bankrupt, long before the discussion is finished on how banks should be run in future.

My conclusion is: Indonesia needs a risk reduction strategy.

Such a strategy can be based on turning weaknesses in the market into strengths.

If Bank Indonesia, the central bank, issues short-term promissory notes in U.S. dollars to overseas investors at the current risk price of 8 percent over Libor for one month deposits, then U.S. dollar capital outflows could be compensated by U.S. dollar capital inflows.

BI could use these funds to expand its foreign exchange reserves buffer (thereby reducing liquidity risks and the volatility in the rupiah's exchange rate), provide U.S. dollars to sound local banks acting as intermediaries to the real sector for international trade financing (thereby reducing liquidity risks, increasing earning levels and reducing counterparty risks), and replace expensive rupiah funding for IBRA's nonperforming assets with much cheaper U.S. dollar-denominated funding (thereby strengthening the rupiah and reducing local interest rates, which reduces exchange rate risks and counterparty risks).

Such a strategy could quickly change market sentiment on financial risk-taking in Indonesia.

The strategy should also focus on the level of foreign debt incurred by Indonesia, on the distribution of the debt in the government and private sectors, on debt maturity levels and on the strengths and transparency of local counterparties (for instance, by having all debt servicing payments to foreign banks channeled through INDRA). Monitoring these areas would also reduce exchange rate and counterparty risks.

Indonesia's monetary crisis has been more severe than in other countries due to its free currency convertibility policy. The same policy, coupled with a risk reduction strategy, can also take the country out of its crisis faster than any other crisis- ridden economy.

All the right elements are still in place. Foreign investors and foreign banks would rather stay in the country provided the risks lead to reasonable gains rather than to losses. Through such a strategy, Indonesia could set an example for the world.

The writer is the country manager for ABN AMRO Bank. This article has been written in a private capacity.

Window: My conclusion is: Indonesia needs a risk reduction strategy. Such a strategy can be based on turning weaknesses in the market into strengths.