SPEAKING
FREELY Indonesia: Asia's weak
link By Marshall Auerback
Speaking Freely is an Asia Times
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Lost amidst the
carnage wrought by Hurricane Katrina have been
ominous developments in Indonesia. President
Susilo Bambang Yudhoyono recently said his
government would raise fuel prices and cut
ballooning subsidies, but failed to outline how or
exactly when it would do so. The government's
penchant for subsidizing fuel is expected to cost
US$14 billion this year - a third of its forecast
expenditure, or 5.4% of gross domestic product.
This is taking its toll on the rupiah, which is
close to a four-year low against the dollar,
falling almost 10% this month. The rupiah's sharp
fall has evoked uncomfortable memories of the
Asian financial crisis of 1997-98.
Indonesia cut fuel subsidies in March, but
the subsequent rise in crude oil prices has more
than wiped out any savings. As a result, Southeast
Asia's biggest oil producer is ransacking its
foreign exchange reserves to pay for imported oil
and to shore up its currency. Forex reserves have
fallen by about $4 billion to $32
billion in the first six
months of this year. That is a comfortable cushion
on most measures, but not one that will bear
sustained intervention.
And in worrying
shades of 1997, the central bank has responded to
the currency's descent on the forex markets by
raising rates: the benchmark interest rate has
been raised already by 125 basis points to 10.5%,
but still no concrete action on the source of the
current problem - fuel subsidies - has been taken
by the government. In an effort to deliver on that
promise the president last week, for the first
time, stated that his government would raise
prices and cut subsidies that he said could reach
Rp138,600 billion ($13.6 billion) this year, or
roughly a third of central government
expenditures.
But Yudhoyono said his
administration would draft a compensation plan in
September and October, signaling a move to raise
fuel prices in November at the earliest. And it is
unclear whether the markets will give him that
sort of breathing space. Politically, one can
understand the president's hesitation. Anger over
rising fuel prices helped to topple Suharto in
1998, and there are also lingering concerns that
the country's vulnerability could be exploited by
resurgent Islamic fundamentalists, whose influence
has grown over the past few years in this
predominantly Muslim country.
Although
economists generally describe Indonesia's
fundamentals as "strong", bankers fear that
without a solid response from Jakarta, Indonesia's
currency weakness could grow into a crisis. Should
the currency remain below Rp11,000-12,000 to the
dollar for a quarter, they say, it would put
pressure on the banking system, given the
prevalence of dollar-denominated debt in the
system.
It is advisable to take any
positive comments about Indonesia's "strong
fundamentals" with a huge chunk of salt, given
that similarly confident pronouncements were made
on behalf of Thailand and Korea a short while
before the two nations were plunged into crisis.
Literally four months after praising the economic
performance of Thailand and Korea in its 1997
annual report, its then managing director, Michel
Candessus, blamed Asian governments for the deep
failures of macroeconomic management and financial
policies that the IMF had discovered only when the
countries' financial crises erupted.
In
fact, right up to the eve of July 1997, the
continued fast growth of the "miracle" economies
of East Asia looked to be one of the certainties
of our age (about as certain as China's ongoing
growth story appears today). None of the four main
crisis-afflicted countries (South Korea, Thailand,
Malaysia, Indonesia) had had a year of
significantly less than 5% real GDP growth for
over a decade by 1996 - Korea not since 1980,
Thailand not since 1972. The crash was even more
devastating to people's living standards and sense
of security than the Latin American crash of the
1980s. Some estimates suggest that around 50
million of the combined 300 million-plus people of
Indonesia, Korea, and Thailand fell below the
nationally defined poverty line between mid-1997
and mid-1998. Many millions more who were
confident of middle-class status felt robbed of
lifetime savings and security. Public expenditures
of all kinds were cut, creating "social deficits"
that matched the economic and financial ones.
Indonesia's real GDP shrank 17% in the first three
quarters of 1998, Thailand's 11%, Malaysia's 9%,
and Korea's between 7 and 8%. It took nearly two
years to reach the bottom.
So the costs of
procrastination for the Indonesian government are
enormous. To be sure, there are some significant
differences between now and 1997. For one thing,
virtually all of the emerging Asian economies are
running significant current account surpluses, in
stark contrast to the time that the 1997 crisis
emerged, when the appreciation of the US dollar,
the depreciation of the Japanese yen and the
Chinese yuan led to a loss of export
competitiveness in Asian economies whose
currencies were effectively pegged to the US
dollar. The capital inflows exacerbated the real
appreciation of the Asian currencies. The
appreciation raised input prices relative to
output prices, squeezing profits and hurting
export growth. The Japanese recession reduced
export profits. As a consequence of these external
"shocks", Thailand, Korea and Malaysia developed
large and out-of-character current account
deficits.
As manufacturing came under
pressure, more and more investment went into the
property market and the stock market. In Thailand,
Malaysia, and Indonesia, asset bubbles began to
blow out and the fringe of bad industrial
investments also expanded. To be sure, there are
not the same signs of excess today. Foreign
exchange reserves remain ample across the region.
In the case of Indonesia itself, exports in July
rose 17% to $6.99 billion, while imports rose 15%
to $4.8 billion. For the past several months, the
country has been running a trade surplus of
roughly $2 billion per month and has not shown
much change in recent months despite higher oil
prices (Indonesia has become a net oil importer,
despite being Asia's largest producer).
But there is little question that a lot of
capricious Western speculative capital remains in
the region, largely a repository of the "Chinese
revaluation trade". In spite of the comparative
paucity of China's original revaluation (or
perhaps because of it), a lot of hot money has
remained in the region betting on more to come.
Funds have flocked to other obvious "revaluation
beneficiaries", such as the Singapore and Hong
Kong dollars, the Malaysian ringgit, and the
Korean won. Were the Yudhoyono government to
continue to defer taking tough decisions on fuel
subsidies (which in themselves could trigger much
domestic unrest), that money could start quickly
flowing out of the region. Already we are seeing
some sort of indirect contagion effect as
currencies such as the Singapore dollar, in spite
of the latter's robust fundamentals, have begun to
weaken as well against the greenback.
Not
only is this "hot money" an ongoing source of
potential financial instability in Asia, but very
few people demonstrate an understanding of the
nature of the flows themselves, which even today
are largely speculative in nature, as opposed to
stable Foreign Direct Investment (FDI). Most
market participants are now familiar with standard
derivative contracts used in hedging risk, such as
forward contracts, futures and listed options.
Banks also offer derivative contracts to their
clients in the over the counter market (OTC), but
there is no market involved in these contracts,
and they are (as the 1997 crisis vividly
illustrated) individually tailored, usually highly
complex combinations of financial instruments
packaged together with derivative contracts
designed to meet the particular needs of clients.
Rather than committing their own capital,
the banks often serve in these transactions as
intermediaries whose services largely involve
creating vehicles that attract widespread retail
interest via securitization. And the major
objective of these institutions is not so much the
maximization of profits via seeking the lowest
cost of funds and channeling them to the
highest-risk adjusted return, but rather in
maximizing the amount of funds intermediated and
collecting higher fees and commissions.
This means a shift from continuous risk
assessment and risk monitoring of funded
investment projects that produce recurring
interest income over time to the identification of
derivative packages that produce large single
payments to the banks, the ultimate impact of the
risk never really fully assessed or understood
until a crisis eventuates, as was the case in 1997
where the magnitude of the change in the exchange
rates of, say, the Korean won, or Thai baht, were
so extreme as to transform the very nature of the
underlying character of the derivatives packages
at the forefront of these capital flows.
There is no way to control these volatile
flows in today's world of derivatives-charged
international finance, particularly against a
backdrop of extraordinary global liquidity, often
wrongly described as "excess savings in search of
more efficient returns on investment". Such flows
are persistently justified in terms of (a)
maximizing the efficiency of capital worldwide,
(b) allowing a specific country to invest more
than could be financed from its own savings, (c)
bringing modern financial institutions into the
country, and (d) deepening the liquidity of the
country's financial system and lengthening
investor horizons, thereby making markets more
efficient and more stable. In the end, the case
for free capital flows came down to the classic
theory of comparative advantage, as though trade
in dollars was essentially similar to trade in
widgets.
It is hard to make the case that
speculative Western portfolio flows have actually
maximized the efficiency of capital worldwide. The
rising inflow of foreign capital - mainly bank
loans and portfolio capital rather than foreign
direct investment - has gone disproportionately
into unproductive activities with a high component
of speculation, such as real estate. The continued
fast growth rates (that supported the perception
of an unchanging "miracle" in Southeast Asia) has
concealed a rise in the ratio of "bubble" to
"real" growth. This is largely a function of the
fact that Asia already is the world's largest
repository of global savings and much of its
productive manufacturing sector can be financed
internally, pushing foreign capital into
increasingly marginal investments with poor
prospects of return.
The larger result,
therefore, has been a series of booms and busts
("a boom in busts"). Capital flows into emerging
markets turn out to be strongly auto-correlated,
especially within regions, propelled less by
differences between countries in their
"fundamentals" (including "good" or "bad" policy)
than by "push factors" - macro push factors like
the amount of excess liquidity in different parts
of the core zone of the world economy; and micro
push factors like the incentives on institutional
money managers. Money managers tend to be
evaluated relative to the median performance of
money managers in the same asset class. This
encourages them to move in and out of markets
together, producing "herding" or "trend chasing"
or "positive feedback trading."
It is true
that Indonesia has staged a significant turnaround
since the Asian financial crisis. But it would be
wrong to be too complacent, given that the country
still bears significant scars from the previous
crisis. And though asset bubbles are not as marked
throughout the region as they might have been
during the mid-1990s, there is little doubt that
the countries' ongoing efforts to suppress the
rise of their respective currencies against the
greenback have generated new kinds of domestic
credit bubbles, Indonesia included. So a
precipitous withdrawal of western capital,
although perhaps not presaging something as severe
as 1997-98, would still have unpleasant
implications for the global financial system. And
it wouldn't take long before we also began
question whether these flows did actually optimize
market efficiency in a manner constantly
reaffirmed by our soon-to-depart Federal Reserve
chairman. There would be an element of poetic
justice if another financial crisis were to erupt
on his watch, although, as usual, someone else
would be the one to suffer the consequences of Mr
Greenspan's ongoing embrace of New Era economics.
Marshall Auerback is an
international strategist with David W Tice &
Associates, LLC, a US Virgin Islands-based
money-management firm. He is also a contributor to
the Japan Policy Research Institute. This article
first appeared in PrudentBear.
Speaking Freely is an Asia Times
Online feature that allows guest writers to have
their say. Please click hereif you are interested in
contributing.
