Risk reduction strategy needed

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.