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Abstract
The currency crisis in Southeast Asia in 1997 primarily reflects homegrown shortcomings in the national economic strategies of Thailand, Malaysia and Indonesia. Crony capitalism and an economic model that favored runaway economic growth over financial stability have been largely responsible for the financial turmoil.
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LEIF RODERICK ROSENBERGER
The currency crisis in Southeast Asia in 1997 primarily reflects homegrown shortcomings in the national economic strategies of Thailand, Malaysia and Indonesia. While international factors (such as the devaluations of the Japanese and Chinese currencies and NAFTA) all contributed to large and destabilizing current account deficits, crony capitalism and an economic model that favoured runaway economic growth over financial stability have been largely responsible for the financial turmoil. So far, the policy response of the "Asian tigers" has been piecemeal and inadequate. Until this policy paralysis changes, investors will remain jittery about the region and financial. turbulence will frustrate economic recovery and political stability.
Introduction
"It was the best of times, it was the worst of times". These words were used by Charles Dickens in his book A Tale of Two Cities. But these same words could just as easily be used today to describe the rise and fall of the economies in Southeast Asia. Just a few years ago, the World Bank singled out the economies of the "Asian tigers" as models for long-term economic development. It seemed like "the best of times".
Not anymore. Nineteen ninety-seven was a nightmare for the region. In July this year currency traders savagely attacked the Thai baht. Before long, the currency crisis spread across Southeast Asia. After forcing an 18 per cent depreciation of the Thai baht on 2 July, currency speculators quickly turned on other neighbouring countries. The Philippines was next in the firing line. Manila tried to resist the currency onslaught by spending hundreds of millions of dollars defending the peso before finally giving in and floating the peso on 11 July. Then came Malaysia, where the central bank jacked up interest rates to 50 per cent and spent billions of dollars before surrendering on 14 July. The ringgit promptly plunged to a 33-month low.
Indonesia's currency band helped it weather the storm for awhile. But in the end, Jakarta's more flexible foreign exchange policy only delayed the onslaught. Before long, Indonesia's chaotic microeconomic conditions also made it a ripe target for a currency attack. Even a well-run economy like Singapore was soon caught up in the regional contagion. By the middle of the summer, some observers naively thought that the worst was over. The International Monetary Fund (IMF) was hopeful that its US$17.2 billion rescue package for Thailand could somehow contain the problem. But after a period of relative calm, the day of reckoning arrived for all the years of go-go growth, crony capitalism and overborrowing. Evidence of a massive foreign debt problem and a teetering banking sector soon surfaced, which in turn made investors jittery in phase two of the crisis.
The result has been a vicious spiral of falling currencies, collapsing stock prices, and growing fears of corporate bankruptcies and banking failures. Before long, Indonesia, once the darling of the IMF and World Bank, had to approach these Bretton Woods twins for an embarrassing rescue package of its own. Then, in phase three of the crisis, the inability of the political leadership in Asia to respond effectively to the deep-rooted financial turmoil triggered a stock market crash in Hong Kong, which before this was thought to be an island of stability in a turbulent region. The financial turmoil in Hong Kong quickly spread to Wall Street and the other financial capitals around the world. After a much needed correction, strong fundamentals in the U.S. economy will probably help Wall Street make a gradual but steady recovery. Unfortunately, the collapse of global investor confidence in Asian markets is likely to last for some time. One thing is certain: in Southeast Asia, it is "the worst of times".
While it is always risky to generalize, it might be helpful to examine some common elements of what we might call the Southeast Asian economic model. We will then take a close look at three of these economies -- Thailand, Malaysia and Indonesia - and explore what went wrong for each of them. In the process, we will learn how each of them might turn their economies around.
Southeast Asia's Economic Model
During the best of times, most of the "Asian tigers" believed that a rocksteady currency was the fundamental foundation for their economic success. For over a decade, they generally held their currencies stable against a basket of currencies dominated by the U.S. dollar. Currency stability inspired confidence among traders and foreign investors. Economic relations with them consequently appeared to be relatively risk free. For much of the decade from 1985 to 1995, Japanese manufacturers, in particular, saw Southeast Asia as an attractive production refuge from a strong yen. Southeast Asian currencies virtually pegged to a weak U.S. dollar gave "tiger" exports a competitive shot in the arm. In the boom years of 1994 and 1995, their weak currencies attracted huge capital inflows. Much of it was Japanese money. But despite these capital inflows, "tiger" governments, anxious to maintain price advantages for their exports, generally resisted pressure for their currencies to appreciate against the dollar. The result was an unhealthy surge of domestic liquidity. The combination of high national savings and large capital inflows produced huge pools of financial capital, which businessmen used to drive economic growth. Add cheap labour to the mix and it was little wonder that this economic formula helped the manufacturing exports of the "Asian tigers" grow by leaps and bounds.
The flip side of weak "tiger" currencies (which were making their exports so attractive) was a strong yen that was undermining the export competitiveness of Japan. In 1995, the United States and Japan agreed that a stronger dollar and a weaker yen were in the national interests of both countries. Between 1995 and 1996 the U.S. dollar rose 40 per cent against the yen.1 Since "tiger" currencies were generally pegged in a de facto sense to the rising U.S. dollar, the price of "tiger" exports became less competitive in 1996 and 1997. Meanwhile, in January 1994, China devalued its currency by 50 per cent against the U.S. dollar. This gave China the potential to radically underprice its manufactured goods compared to those of the "Asian tigers". This new export price advantage (plus the new export capacity that China was bringing on stream) hurt "tiger" exports in 1996.
Developments in North America and Europe also contributed to the Asian export slow-down. For instance, there was a shift in the sourcing of U.S. textiles from Asian suppliers to Mexico and Canada as a result of the North American Free Trade Agreement (NAFTA). The Asian share of U.S. textile imports consequently fell from 68 per cent in 1990 to 40 per cent in 1996.2 In addition, the stagnant economies of continental Europe (as well as Japan) turned out to be especially poor customers for the increasingly expensive "tiger" exports. As a result, almost all Southeast Asian exports began to stumble in 1996. For instance, the contrast between Thailand's merchandise export growth in 1995 (25 per cent) and Thai export growth in 1996 (0 per cent) was startling. This zero Thai export growth in 1996 pushed the Thai current account -- which measures trade in goods and services - into a huge deficit of 8 per cent of gross domestic product (GDP). Given these trade difficulties, Wall Street and other financial capitals perceived the currencies of the "Asian tigers" as overvalued. And the more overvalued a currency, the greater the perception that the situation was unsustainable, and the greater the incentive for speculators to attack it.
Large Current Account Deficits
Why were the "tigers" not more concerned about the high current account deficits? Their leaders conceded that large current account deficits could be a bad thing, but they made the logical economic argument that if a current account deficit mostly reflects higher investment, it would eventually increase an economy's competitiveness and therefore its ability to repay the debt, and would certainly be more sustainable than a deficit driven by consumer spending.
"Tiger" leaders were also quick to contrast their investmentoriented current account deficit with Mexico's consumption-driven current account deficit. In fact, in the four years to 1994, four-fifths of the increase in Mexico's current account deficit reflected lower savings and increased consumption. In contrast, the widening of most of these Asian economies' deficits reflected higher investment, not consumption. On the surface, all this made perfectly good sense. But the underlying assumption here was that most of this "investment" spending was intelligent and potentially profitable. Unfortunately, nothing could be further from the truth. As will be seen, much of the so-called investment was foolishly spent on property development, resulting in an oversupply, and redundant manufacturing capacity rather than improvement in the quality and competitiveness of "tiger" exports.3 In addition, "tiger" leaders generally dismissed Thailand's zero export growth as primarily "cyclical", reflecting potentially reversible factors such as weak demand in Japan and Europe and the rising U.S. dollar. They hoped that both factors would somehow turn around in 1997. Such wishful thinking was no substitute for a coherent strategy and would come back to haunt them in the months ahead.
Structural Faultlines
In some ways, the wishful thinking was understandable. After all, the countries of Southeast Asia had enjoyed phenomenal economic performance for over a decade. This success tended to blind "tiger" leaders to the shortcomings of their export-led economic model. Years of rapid growth had obscured numerous structural problems that desperately needed attention. These long-term problems would combine with the cyclical problems cited above to make a revival of exports increasingly unlikely. For a start, manufacturing competitiveness was falling fast. Malaysian wages, for instance, climbed by 11.4 per cent in June of 1997, but productivity managed only a 1.4 per cent gain.4 Meanwhile, labour costs in Thai integrated circuit factories were now three times as high as those in similar plants in Shanghai. Similarly, rising wages in such traditional labour-intensive export industries as garments and footwear priced Thailand and other "tiger" economies out of this traditional export market.5
In other words, the countries of Southeast Asia face severe structural problems that go beyond regular business cycle difficulties. In this difficult transition period, they must move their economies to higher and more sophisticated levels. Presently, too many of their technicians and managers are ill-equipped to make the next leap to knowledgeintensive, high technology industries.
In addition, the blame for the slow-down in export growth also rests with some corrupt, unresponsive "tiger" politicians who cared more about profiteering from political office than transforming their society for challenges in an increasingly competitive global marketplace. Instead of using slush funds to line the pockets of politically well-connected businessmen, they should have allocated this money to improve the minds of students in rural schools, or worker skills in city factories. Addressing this problem requires serious reform of the traditional old-boy capitalism that generated an impressive but relatively short-lived prosperity.
Rote Learning
But even in the Asian schools which are adequately funded, too many still stress repetitive rote learning, rigid curricula and blind obedience to authority. This dogmatic approach has produced disciplined and politically docile workers for success in low technology industries. But these backward schools have failed to develop innovative, imaginative technicians and managers with creative thinking skills for success in fast-paced, constantly changing knowledge-based industries.
During this uncomfortable transition between low technology and knowledge-based industries, it is possible for some of the "tigers" to salvage their struggling industries. For instance, Thailand could remain in the garment and footwear business if it develops a market niche in fashion footwear and designer clothing. But "moving uptown" in the apparel sector also requires a flair and creativity that the "tigers" have not demonstrated in the past. "Tiger" industries have tended to merely copy successful rivals, or make up orders on demand. "Tiger" schools and job training need to make a quantum leap from training memories to educating minds to think for themselves. It also means unlocking the creative energies of every Asian man or woman to break away from the pack and fulfil their unique potential, rather than repressing such exuberance by demanding unwavering allegiance to group conformity.6
Meanwhile, the rigid economic model of the "tigers" made it increasingly difficult for them to adjust to the new realities of a rising current account deficit. If the "tigers" had been in a floating exchange rate system, the large current account deficit would have caused the baht to gradually depreciate. A weaker currency would have increased the demand for their exports and decreased consumption of imports. That in turn would have lowered the current account deficit and made it possible for them to balance their payments without the need for huge (and potentially destabilizing) capital inflows. But even when the financial crisis became impossible to miss, "tiger" governments still had a rigid mindset about stable currencies being the centrepiece of their economic success in the previous ten-year period.7 Conditioned by years of rote learning and bound in their mental straightjacket, it was impossible for "tiger" leaders to imagine economic success in a floating exchange rate system.
The Thai Experience
The "tiger" fixation with stable currencies was particularly apparent in Thailand. In a country with more than its share of political and economic turmoil, the currency peg seemed to many as the only stable thing left in Thailand. Consequently, the Thai Government refused to let the baht adjust to a 40 per cent rise in the U.S. dollar against the yen from 1995 to 1996, despite a rising current account deficit. Given the Thai determination to keep the baht stable, some way had to be found to prop it up and counter the downward pressure on the baht from the large current account deficit. Bangkok's fatal "solution" was to raise domestic interest rates to punishingly high levels. These high interest rates had a deleterious effect on the economy in a number of ways.
First, the high interest rates exacerbated problems in the property and banking sectors. The high interest rates had a particularly negative effect on property developers and made it virtually impossible for many to pay back their bank loans. At the same time as these nonperforming loans began to pile up in the banks, high interest rates were also deflating the value of banking assets, thus crippling the solvency of the embattled financial sector. This caused corporate earnings and stock prices of Thai financial companies to plunge.
In addition, high interest rates hurt many manufacturers. It artificially strengthened the baht, which in turn made exports less competitive. The high interest rates also caused Thai consumers to be more spendthrift, which in turn shrank aggregate demand at home. That caused the economy in 1997 to grind to a virtual standstill. As the liquidity and asset problems of banks and corporations began to multiply, they turned to the Thai central bank for relief. But the central bank told the business and banking communities that there simply was not enough money to go around.
Cheap Foreign Money
The punishingly high interest rates made it a non-starter for Thai businessmen to borrow money at home in baht. That prompted increasing numbers of Thai borrowers to go overseas for cheap capital. Thai financial firms assumed it was perfectly safe to take out foreign loans for their business clients. The result was a flood of cheap foreign money that allowed banks to make foreign currency loans in U.S. dollars at interest rates far lower than loans in baht. In the two-year period from 1995 to 1996, foreign borrowing by Thai financial firms almost doubled.8 By 1996 Thai companies and individuals had piled up huge U.S. dollar debts. In fact, by 1996 they owed more than US$70 billion. That figure amounted to half the country's gross domestic product (GDP). This huge capital inflow covered the current account deficit in the Thai balance of payments. But was the problem solved? Not exactly. On the surface, all was well. But not all capital inflows are the same. Had Thailand been receiving a lot of foreign direct investment, this relatively "permanent" money would have contributed to financial stability. Instead, Thailand was using a dangerously high percentage of short-term capital, or "hot money", to cover its current account deficit.
If financial stability had been a Thai goal, such "hot money" flows were certainly not a dependable way to achieve it. Consequently, the investment-rating agency Moody's downgraded Thailand's shortterm debt rating. Moody's correctly argued that this over-reliance on volatile, footloose money made Thailand increasingly vulnerable to a Mexican-style financial shock. The IMF told Bangkok much the same thing. Bangkok ignored the warnings.
Over-capacity
Before long, the Thai economy became addicted to cheap foreign currency. The huge capital inflows left Thai banks awash in cash. The banks asked themselves, "What should be done with all this money?" They turned around and lent too much of this huge pool of excessive liquidity to politically well-connected businessmen for hare-brained schemes. Using this cheap money borrowed overseas, Thai companies over-invested in redundant manufacturing plants. The private sector, used to growing simply by investing, gave little or no thought to the actual demand for this new capacity. In fact, other Asian governments were already struggling with a serious problem of excess manufacturing capacity. And yet, Thailand kept building more factories. The country became burdened with a surplus of virtually idle steel mills and petrochemical plants.
Worst of all, Thai residential property companies kept sinking money into too much land and property it could not sell. As a result of this reckless speculation, a huge property glut developed, with one unoccupied high rise condominium after another dotting the landscape. Nearly twelve years of residential property inventory sits empty. In Bangkok alone, 250,000 houses and apartments are lying empty. As one observer put it, "The Thais love to invest in bricks and mortar".
Meanwhile, construction continued at a furious pace with the blind assumption that falling asset values would somehow go up despite ample evidence to the contrary. In the words of one Thai banker, "I have often been impressed by my fellow Thai investors' insistence on their right to lose money".
The Financial Crisis
Revelations that several Thai finance companies were over-exposed to the foreign-financed property glut triggered a speculative attack on the baht in early February 1997. By March, Bangkok was facing the most serious financial crisis in Thai history. To overcome the acute liquidity crisis, Bangkok tried a few ad hoc measures to defend the baht. But by the middle of May, currency traders resumed their onslaught.
In response to the May attack on the baht, Bangkok tried to shore up the financial sector through bank mergers. But it did not make sense for ailing banks to drag down relatively healthy ones. This became increasingly apparent when a well publicized attempt for a merger involving Finance One collapsed. By the end of June 1997, about 12 per cent of bank loans and 20 per cent of finance company loans were nonperforming, involving a total of about 1 trillion baht or 20 per cent of GDP. By the end of May, finance companies had liabilities of 1.39 trillion baht, outstanding foreign loans worth 111 billion baht, and outstanding promissory notes worth 912 billion baht.9
Blind Optimism
Despite optimism in Bangkok that things would get better, the economic data continued to paint a negative picture. The grim facts included a slow-down in Thai exports and GDP growth, and a sharp fall in the stock market. Then in early May, budget data for the first half of fiscal 1996/1997 revealed a serious deficit of almost 54 billion baht. The government kept reacting to the bad budget news with one anaemic budget cut after another.
Meanwhile, Bangkok's credibility was further undermined by yet more incoherent economic policy-making. Prime Minister Chavalit Yongchaiyudh was a traditional Thai politician incapable of tackling tough issues or managing the economic crisis. Chavalit has a talent for political manoeuvre but no economic vision of his own. As a result, the Finance Ministry, the Bank of Thailand and two sets of economic advisers reportedly fought among themselves while vying for Chavalit's ear.
On 19 June, Finance Minister Amnuay Virawan, totally frustrated with the inadequate response of Thai politicians to the financial turmoil, resigned from his position. After the announcement, the Thai stock market fell to an eight-year low of 465. The appointment the next day of Thanong Bidaya as Amnuay's successor and Thailand's fifth Finance Minister in two years brought only a short-lived revival of confidence in financial markets. But a few days later, more economic bad news was released. The data showed that unexpectedly high imports had caused the current account deficit to balloon. With a shortfall of capital inflows, Bangkok had to use US$4 billion of foreign reserves between the end of April and the end of May to cover a balance of payments deficit.
On 2 July, after spending billions of dollars trying in vain to maintain the baht at around 25 baht to the U.S. dollar (where it had stood for more than a decade), Bangkok announced a managed float, thus abandoning the peg to the dollar. Unfortunately, Bangkok offered the markets no coherent economic strategy to accompany the so-called managed float. By early September, the baht went into a nose-dive, dropping to the 38 baht to the U.S. dollar threshold, or a fall of 32 per cent against the dollar since July.
With no credible way to plug the hole in its balance of payments or to finance more rescue schemes, Bangkok was forced to look for outside assistance. In early August, the Thai Government accepted IMF conditions for a US$17.2 billion financial package.10 The IMF programme includes about US$6.5 billion from the IMF and other multilateral institutions (the World Bank and the Asian Development Bank), and the rest from countries in the region,ll several of which were already struggling with their own currency crises.
The major part of the IMF programme money is to be used only for balance of payments support, to stabilize the balance of payments and maintain optimal reserves. None of the money is to be used to rescue distressed Thai finance firms. The Bank of Thailand bowed to pressure from the IMF to abandon its previous policy of rescuing ailing finance companies.
The IMF has made it clear to Bangkok that aid to the struggling financial sector will no longer be open-ended as in the past. From now on, any rescues must be funded out of a budget surplus. And that means balancing the budget will have a higher priority than recapitalizing failed banks and finance companies. The increase in value-added tax (VAT) and budget cutbacks are intended to bring the budget back into balance in 1997-98.
Overall, the IMF package undoubtedly contains some tough and impressive items. But given the magnitude of the problem, it lacks credibility. It is simply inadequate to deal with the scale of the ongoing crisis. And the currency market reflects that grim reality. Since the end of 1996, reserves have fallen almost US$10 billion (from US$37.7 billion to US$27.9 billion as of 14 August 1997). On 21 August, Bangkok revealed that the central bank had some US$23.4 billion in forward contracts with foreign and Thai investors that it had taken out to defend the baht and that would become due in the following twelve months. In addition, the current account deficit is projected to be at least US$10 billion a year.
With capital inflows in doubt and nearly US$40 billion in shortterm loans coming due, it is easy to see that the forward contracts alone could eat up a large chunk of the US$17.2 billion IMF package. Of course, it is possible that Bangkok can convince some lenders to roll over some of the forward contracts. But there is no assurance this will happen. Meanwhile, none of the IMF money can be used to help the ailing Thai financial institutions. The main source of support for these finance houses will be a budget surplus of about 51 billion baht. This is a very small amount of money considering the fact that it took 500 billion baht to bail out banks and finance companies in 1997 and 180 billion baht to save the BBC in 1996. And that is just the tip of the iceberg. The cost of bailing out all the other finance houses looks even bleaker in the future. Standard and Poor's estimates that Bangkok might have to bear a total cost equivalent to 12-15 per cent of 1997 GDP in rescuing the finance houses. Of course, the war cry of many economists is to let these finance houses go bankrupt. To the free market advocates of "creative destruction", letting the finance houses go bankrupt seems like a logical approach.
The collapse of financial houses does, however, have other negative repercussions. While it is true that half their loans went into ill-advised property loans and consumption, the other half provided the essential function of funding small businesses. Gutting the finance houses means that many small- and medium-sized businesses will now have no access to funds. As these firms fail because of the liquidity squeeze, many bigger companies that depend on their businesses could fail as well.
Massive corporate bankruptcies will reduce revenue for the government, thus eliminating even the tiny budget surplus of 51 billion baht set aside to help the finance houses. It could well drive the budget into a significant deficit. And since many of the failing Thai businesses used to produce exports, the current account deficit is likely to be much higher than US$10 billion a year. That could rapidly deplete most of the US$17.2 billion in the IMF package and start depleting the US$25 billion reserves Bangkok is supposed to maintain. One whiff of this scenario would be enough to trigger a balance of payments crisis.
Similar doubts about the credibility of the IMF programme are widespread and have been amplified as the true scale of the ongoing Thai crisis began to be revealed. In fact, the perception that the IMF programme is inadequate continues to cause the baht to fall. At the time the baht floated, the exchange rate was 25.80 baht to the U.S. dollar. On 19 August, the day the Thai Cabinet approved the IMF deal, the baht fell to a new low of 32.70 baht to the U.S. dollar. On 21 August, the day the IMF approved the package, the baht hit another new low of 34.25 baht to the U.S. dollar. Then on 3 September, news that Standard and Poor's was downgrading Thailand's local and foreign currency debt ratings and that Finance One would not meet its interest payments caused the baht to fall another 7 per cent (from 35 baht to the U.S. dollar to 37.85 baht to the U.S. dollar).
An Inadequate Response
Meanwhile there have only been a few mildly encouraging signs that the Thai Government is trying to improve the situation. For instance, a new constitution was passed in September aimed at reducing money politics. In addition, in October Bangkok announced a package of measures aimed at plugging a few of the gaping holes in the financial sector. But these efforts do not even begin to address the fundamental problems in the Thai political economy. In fact, three months after the IMF's US$17.2 billion bail-out, Bangkok still had not produced a detailed recovery plan. Without it, the presently inadequate IMF rescue package might end up in shreds.
The inability of the Chavalit government to respond adequately to the severity of the crisis has understandably frustrated the Thai people. Throughout October, throngs of street demonstrators had called for Chavalit's resignation. On 3 November they got their wish. Embattled Prime Minister Chavalit announced he would resign after a stormy eleven months in office.12 Chavalit's resignation followed shortly after the resignation of Thanong Bidaya, his second Finance Minister. A caretaker government will try to keep a lid on things until new elections are held. That will not be easy. With no end in sight to the financial melt-down, the political instability will likely continue.
Meanwhile, the financial turmoil in Thailand was quickly spreading to the other Asian "tigers". For instance, from early July, when the crisis began, until 28 August, the Malaysian ringgit depreciated against the U.S. dollar by more than 15 per cent to M$2.875. Similarly, since the stock market's high point back in February, Malaysian shares had lost more than M$300 billion (US$108 billion). This is more than double Malaysia's 1996 GDP.
Evil Speculators?
What was going on? Malaysian Prime Minister Mahathir Mohamad said that it was all very simple. He blamed everything on greedy speculators like George Soros.13 "We have worked 30 to 40 years to develop our countries to this level but along comes a man with a few billion dollars, and in a period of two weeks has undone most of the work we have done."14 Dr Mahathir also claimed that Soros attacked "tiger" currencies in reprisal for letting Myanmar (reportedly guilty of human rights violations) become a member of ASEAN. He concluded by saying that currency speculators should be treated like common criminals. But is it really that simple? Are Western devils the problem? Of course not. Dr Mahathir's explanation is not convincing to those who understand the currency crisis in the region. That does not mean that international factors are irrelevant. As cited earlier, weaker Japanese and Chinese currencies, and trade diverting NAFTA, seriously damaged the export prospects for "Asian tigers", which in turn widened the current account deficits of most of these countries.
One obvious way to strengthen a falling Malaysian ringgit, for instance, would have been to raise interest rates. Instead, Malaysia kept interest rates low, which predictably weakened the currency. It is hard to blame that mistake on foreign speculators.
The situation in Malaysia jolted investor confidence throughout the region, with stock markets in the Philippines, Thailand and Singapore plunging to lows not seen in several years. Although Malaysia's problems are less severe than those of neighbouring Thailand, they share a similar genesis and ill-fated policy development. Malaysia's export-led growth in the late 1980s led to a construction boom. That boom stemmed from a conscious decision to emphasize rapid growth over financial stability. Of course, it took awhile for the day of reckoning to arrive. For nine years, this national economic strategy produced impressive annual economic growth of 8 per cent. Symbols of this growth are visible for all to see if one travels around Malaysia. Kuala Lumpur boasts the Petronas twin towers, the world's tallest building. Just outside Kuala Lumpur, one of the world's most advanced airports is nearing completion. And everywhere you go, you see the Proton, the national car, on the clogged streets of Malaysia.
Moreover, Malaysia's list of extravagant future projects seems never ending. These include a multi-billion dollar project to lay a road over peninsular Malaysia's mountainous spine; a project to reclaim six islands off the sparsely populated northwest coast and build an international airport on one of them, costing M$30 billion; and the multimedia super information corridor in the twin cities of Putra Jaya and Cyberjaya. The mega-project will cost M$35 billion to build. Other budget busters include plans to build the longest bridge in the world linking Malaysia to the Indonesian island of Sumatra; a M$13.6 billion Bakun dam in the remote jungles of Borneo, as well as a new administrative capital for the state of Sarawak in Borneo.15
In the past, the construction boom was sustained by bank lending to property rather than to manufacturing. Now export growth is sputtering just as an impending property glut threatens to drive values down and increase the mountain of non-performing loans that are hitting the banking sector. Banks are saddled with a level of domestic indebtedness that amounts to a staggering 170 per cent of GDP. In short, the day of reckoning for all of this overborrowing has arrived. These large infrastructure projects require heavy imports, which keeps driving the current account deficit higher and higher. The problem is: how do you keep financing all these mega projects in a credit crunch?
Kuala Lumpur's response to the crisis continues to be inadequate. The latest blow to investor hopes was the release of the 17 October budget. There were no significant cuts in infrastructure spending and no coherent strategy to reduce the current account deficit.
Indonesia Weathers First Storm
Indonesia was initially spared the worst of the currency turmoil because of its exemplary macroeconomic policies and performance.16 For awhile, it boasted strong economic growth, a balanced budget and a sensible monetary policy. Most importantly, Indonesia started as early as 1995 to widen the fluctuation bands for the rupiah against the U.S. dollar. That allowed a gradual depreciation of the rupiah (by some 4-5 per cent per year) to take place, which in turn served as a marketbased shock absorber to prevent the emergence of serious exchange rate distortions.17
These responsible economic policies produced an impressive overall macroeconomic performance. In addition, its current account deficit was not worrisome since most of it was covered by long-term investment rather than "hot money".18 ls Jakarta also enjoyed a comfortable cushion of US$20 billion in foreign exchange reserves. And instead of squandering these reserves in an attempt to defend the rupiah, it kept its interest rates high in order to fortify the rupiah. The fortunes of the stock market have mirrored those of the rupiah.
All of this boosted investor confidence and enabled the rupiah to weather the initial storm. In the days after the floatation of the baht, while the peso and the ringgit were confronted with intense speculative pressure, the rupiah remained largely unaffected and continued to trade within the official 8 per cent band set by Bank Indonesia (the central bank). On 11 July, in a pre-emptive measure designed to undermine whatever speculative pressure there was, the band was widened to 12 per cent. The high level of public confidence in the initial phase of the currency crisis was reflected in the continued strengthening of the market until 8 July, when the stock index peaked at 740.
Phase Two of the Crisis
In short, all was well in Indonesia. Or was it? By the second half of July and early August, following the fall of the baht, the ringgit and the peso, the initial confidence that investors had in the rupiah began to wane. When a new wave of currency attacks hit the Asian market on 21 July, the rupiah dropped to 2,510 rupiah to the U.S. dollar, which was perilously close to the lower end of the 12 per cent intervention band.
The 6 per cent nose-dive was the biggest one day fall for the rupiah in five years. From this point onwards, as the pressure on the rupiah mounted and public confidence in the government's ability to defend it waned, the Indonesian stock market also began to fall.
Why the attack on the rupiah? Some analysts in Jakarta attributed the run on the rupiah to "regional contagion". Indonesian officials argued that the rupiah really was not overvalued. It was merely "guilty by association". Other Indonesian officials thought currency traders selling rupiah were probably making one of two calculations: Indonesian exports would suffer from a strong rupiah following the depreciation of other currencies in the region, or Jakarta would lack the resolve to hold the exchange rate.
This kind of thinking in Jakarta marginalized the significance of the currency trading. Most of all, their macroeconomic virtue in the past blinded Indonesian officials to the possibility that there could be anything fundamentally wrong with other key elements of the economy. This blind spot would soon come back to haunt them. In any event, the initial 21 July attack on the rupiah triggered a sustained stock market fall during the first two weeks of August. To curb a possible stock market melt-down, Bank Indonesia (BI) cut some interest rates by 50 basis points on 8 August. This triggered a renewed currency attack on the rupiah on 13 August. The rupiah was shoved below the 2,682 rupiah to the U.S. dollar floor of the intervention band. For awhile BI was successful in lifting the rupiah up into the currency band by raising interest rates by 100 basis points and selling an estimated US$200 million to US$500 million of its foreign reserves. But it soon became clear that BI would have to spend more and more foreign reserves and boost interest rates even higher to fend off the attack.
Currency traders ultimately doubted the resolve of BI to keep interest rates high for long since this course of action could unleash a banking crisis and generate a rash of corporate bankruptcies. That left BI little choice but to abandon the currency band and let the rupiah float freely. BI's action triggered an immediate drop in the currency's value by some 5 per cent to 2,770 rupiah to the U.S. dollar and a further depreciation of the currency to 2,830 rupiah to the U.S. dollar by the day's end. The currency crisis also provoked a fall in the stock market. Stocks fell from the 720-point mark in early July to below the 600 threshold by 20 August.
If the rupiah fell to 3,000 to the U.S. dollar, earnings growth in the non-banking sector would drop to zero. Bankers were fearful that a continuous rupiah fall of this nature could easily bring down one or more of the large conglomerates. This could also drag down other big business groups because of extensive cross-ownership. Of course, the rupiah has long since fallen below this 3,000 figure. Since the rupiah began its decline, it has lost roughly 30 per cent of its value and was near 3,600 rupiah to the U.S. dollar on 27 October. And this grim reality has brought one conglomerate after another perilously close to bankruptcy.
Why Did the Rupiah Fall?
A rupiah nose-dive of this nature could no longer be attributed to regional contagion or competitive devaluation. The real reason for rupiah vulnerability can be traced to severe microeconomic vulnerabilities in Indonesia.
By the middle of July, currency traders had totally lost confidence in the rupiah when they spotted Indonesian corporations frantically selling rupiah and buying U.S. dollars. Currency traders soon learned the open secret that Indonesian conglomerates had been hiding their real financial condition and were actually much deeper in debt than anyone imagined. While the soft official figure for Indonesia's private foreign debt was US$56 billion, financial market analysts argued that the real figure had to be closer to US$100 billion.l9
The primitive nature of Bank Indonesia's oversight and information about the private foreign debt problem was evident when Soedradjat Djiwandono, the Governor of Bank Indonesia, invited sixty Indonesian blue-chip company executives to his inner sanctum.20 He suspected that each of their companies had at least US$100 million in offshore debt, much of it unreported on their balance sheets. But he was not entirely sure. So the governor gave them each a blank form asking them to report their debts. From a foreign investor standpoint, it is difficult to know what is worse: that Indonesia's companies may have billions in hidden hard-currency debt they cannot repay, given the collapse of the rupiah; or that the Governor of the central bank is clueless and reduced to handing out blank forms to find out what is really going on. Either way, the tale illustrates the severity of the crisis.
Needless to say, such poor disclosure added to the evaporation of investor confidence in Indonesia. The problem is that Bank Indonesia, the only source of statistics on the economy, lacks the regulatory teeth to force well-connected banks to disclose details of their offshore loans. That is why Standard & Poor's and Moody's Investors Service, citing fears of undisclosed debt, decided to downgrade ratings for large Indonesian banks, including Bank Negara Indonesia.21
But it was not just uncertainty about the size of the private foreign debt that troubled currency and stock traders. It was also the nature of that debt that worried everyone. Indonesian corporations were grossly mismanaging their overseas borrowing. For instance, Indonesian firms used shaky property as collateral even though the underlying value of the real estate assets was actually a small fraction of the alleged value at a time of severe property glut.
Worst of all, much of this private debt was unhedged in the sense that Indonesian companies failed to protect themselves against a possible fall in the rupiah's exchange rate.22 Instead of locking in strong rupiah rates in their contracts before the currency crisis, they naively gambled on the rupiah remaining stable. Now that the rupiah has fallen against the U.S. dollar, their unhedged dollar-denominated loans cost up to 34 per cent more to service in rupiah terms.
In a survey by ABN Amro Hoare of twenty-nine large companies, only three had fully hedged their loans.23 Indofood was a case in point. This company recently revised its net profit forecast from Rp500 billion (US$137 million) down to zero or negative. It acknowledged that less than 15 per cent of its US$1 billion debt had been hedged.4 Worse still, somewhere between one-third and one-half of the growing mountain of foreign debt is now short-term and thus due for repayment in the next twelve months. Once Indonesian corporations learned the errors of their ways and that a much more expensive debt had to be paid in a matter of months, they hit the panic button. They started frantically to sell rupiah, thus weakening the rupiah even more. And the further the rupiah fell, the harder it became to service the debt in terms of rupiah.
A No-Win Monetary Policy
BI is now in a no-win situation with regard to monetary policy. In order to keep foreign corporate debt relatively affordable to pay back, it must keep the rupiah as strong as possible. That would normally mean keeping interest rates high to defend the rupiah. And so, on the one hand, BI is justifiably concerned that the rupiah would be severely hit by forward market selling once it indicates a willingness to lower interest rates. On the other hand, the BI is also under severe domestic pressure to cut its high short-term interest rates because of threatened bank collapses.25 Otherwise the high rates could trigger corporate defaults on loans which, in turn, could lead to a collapse of the banking sector. This puts BI in a "damned if you do, damned if you don't" situation, at least when it comes to dovetailing monetary and foreign exchange rate policies.
Fiscal Policy to the Rescue?
Does this mean that everything is hopeless? Not exactly. One painfully difficult but possible way out of monetary policy paralysis is to focus on the fiscal side of the equation. BI can eventually lower interest rates while keeping the rupiah relatively strong if President Soeharto were willing to drastically tighten fiscal policy. That would ease the credit crunch once the government stopped hogging so much of the dwindling pool of national savings. But in the alarming Indonesian financial context, tightening fiscal polily does not mean simply balancing the current budget. It means scrapping all sorts of unnecessary spending programmes.
The overborrowing-required for extravagant government spending on all sorts of white-elephant projects unnecessarily drives up interest rates for worthwhile private sector borrowing. In addition, government mega-projects require expensive imports. These imports involve selling even more rupiah and buying U.S. dollars (or other foreign exchange), thus further weakening the rupiah.
One such white-elephant project is the national car programme. The car programme is slated to receive US$690 million in loans from a consortium of Indonesian banks to start assembling cars. But the plan is unlikely to turn a profit in order to repay the debt. Similarly, the government may be asked to shoulder US$400 million in losses at Chandra Asri, a petrochemical plant.
The Indonesian Government now owes roughly US$50 billion to foreign creditors. This figure was never enough to worry foreign investors until recently. But because of the fall of the rupiah, this government debt is now worth 34 per cent more in terms of rupiah. This figure plus the huge amount of unhedged, short-term private debt justifiably alarms foreign investors.
Their great fear is that the Indonesian Government as well as private borrowers will find it impossible to repay the debt and have to default. This genuine investor fear of default has destroyed investor confidence in the Indonesian market. Consequently, investors as well as Indonesian corporations have begun to frantically sell rupiah and buy U.S. dollars, thus depressing the value of the rupiah. Similarly, the stock market fell almost 30 per cent (from 700 to 515 points) between June and 6 October.
Jakarta's Response
Instead of biting the bullet and sharply tightening fiscal policy, Jakarta's response to the rupiah crisis was initially to resort to currency controls, which predictably backfired. In an attempt to decrease the demand for U.S. dollars and strengthen the rupiah, BI announced on 31 August that there was now a US$5 million limit on lending to any one non-resident customer for foreign market transactions.26 A foreign investor backlash quickly developed against the new limits. Indonesia's forward foreign exchange market promptly dried up. Instead of causing the rupiah to rise, it fell from 2,860 rupiah to the U.S. dollar to 2,960 rupiah. Stocks also lost 1.5 per cent of their overall value.
The new rule only served to generate nervousness about investment in Indonesia. People were confused about exactly what lending was permitted and unsure about how a bank's overall exposure to foreign lending was to be calculated. In a climate where confidence in the Indonesian market was in short supply, the thrust of the new curbs only made a bad situation worse by indicating a significant reversal from Indonesia's commitment to an open capital market.27
To reassure foreign investors who were unsettled by the currency controls debacle, Indonesia announced new economic reforms on 3 September. While most of the so-called reforms were merely promises to cut spending and address the banking turmoil, the government statement that it would lift a 49 per cent cap on foreign purchases of new initial public offerings was a positive signal to investors.28 The stock market rose 6 per cent in response to the announcement.
The positive stock market response reflected Jakarta's relatively level-headed approach to the country's problems. It was also couched in market-friendly language. In a speech to Parliament two weeks later, Indonesia's Finance Minister Mar'ie Muhammad announced the first details of the government's plan for budget cuts and banking reforms. He pledged to cut spending and delay some large infrastructure projects and "review" others in order to soften the impact of rupiah depreciation on its current account and foreign debt. The thrust of the Finance Minister's statement to Parliament was positive. But the speech raised as many questions as it answered. First, could the Soeharto government actually deliver on its plan? Would it be able to get the political backing to implement them? What would be the political impact of the budget cuts? Even if the budget cuts were put into place, would postponing a few projects and "reviewing" other projects be dramatic enough to ease liquidity and allow BI to decisively cut interest rates? Interest rates had come down slowly but were still a punishingly high 20 per cent, or still more than double the size before the currency crisis erupted three months earlier. A number of leading Indonesian companies could not survive much longer unless rates were lowered quickly. And if BI dropped interest rates, could Jakarta maintain some semblance of rupiah strength?
By the last week of September, some of the answers to these questions became more apparent. There were a few mildly encouraging signs. For instance, President Soeharto did suspend a number of projects.
But investors reacted negatively to the US$22 billion worth of large projects he kept in the budget. At a time of financial turmoil, this kind of government profligacy would make it difficult for BI to ease monetary policy without weakening the rupiah still further. And yet BI chose the occasion to do just that and lowered interest rates by 200 basis points.29
Sure enough, the rupiah's value plummeted from about 3,019 rupiah to the U.S. dollar on 25 September (the day of Soeharto's announcement, and interest rates were cut) to about 3,850 rupiah to the U.S. dollar by late September.30 Since August, the rupiah had suffered a 34 per cent decline. Similarly, over the same period of time the Indonesian stock exchange index had lost 30 per cent of its value.
Thus, President Soeharto's budget cuts were not radical enough and the interest rate cuts were premature, given the financial chaos and the stated goal of currency and stock market stability. By the first week of October, it was painfully obvious to Jakarta that investor confidence had collapsed once more. At this rate, it became problematic whether Indonesia could meet the billions of U.S. dollars in short-term debt obligations without rapidly depleting its once ample pool of foreign reserves.
Jakarta Approaches the IMF
If Indonesia hoped to restore confidence in its embattled currency and stock markets, it now had no choice. Like Thailand, the Indonesian Government was forced to approach the IMF and the World Bank on 8 October for financial help.31
Between 17 October and 27 October, the financial turbulence in Indonesia spread to Hong Kong and caused a 33 per cent melt-down in the Hang Seng stock index. Then on Wall Street on 27 October, the Dow Jones stock index dropped 554 points, the biggest one-day point fall in history. Almost everyone agreed that the melt-down in Indonesia and the rest of Southeast Asia were responsible for most of the trauma in global finance.
Regardless of who was at fault for the financial turmoil in Indonesia, it was now difficult to make the case that it had no impact on the rest of the world. Perhaps U.S. Treasury Secretary Robert Rubin said it best: "Financial security round the world is critical to the national security and economic interests of the US."32 Henceforth, the debate after the stock market crash in Hong Kong was no longer whether to rescue Indonesia. The two burning questions on everyone's mind were:
1. How big should the rescue package be? and
2. How tough should the IMF conditions be?
In his initial dealings with the IMF, World Bank and Asian Development Bank officials, President Soeharto reportedly wanted only advice and a relatively modest US$4 billion credit facility without tough conditions. Soeharto felt that this "soft conditions, modest money" package would be enough to restore investor confidence in Indonesia. He also thought that he could get the IMF to agree to it because Indonesia's solid macroeconomic record had always made it the "teachers' favourite" in the IMF class.
But the global financial turmoil was a loud wake-up call to the IMF that a modest money/soft conditions package would not even come close to calming investor jitters. The IMF was also well aware that investors felt that their US$17.2 billion rescue plan in Thailand was inadequate to deal with the size of the financial mess. Thus, any financial package for Indonesia had to be big enough to ward off the risk of a global contagion, that is, keeping the financial instability in Southeast Asia from spreading to one global stock market to another.
Given the global financial volatility, it was not a surprise when, on 31 October, the IMF announced a large US$23 billion rescue package for Indonesia.33 The three-year package, including a US$10 billion loan from the IMF, US$4.5 billion from the World Bank, and US$3.5 billion from the Asian Development Bank, is the biggest international financial rescue plan since the US$50 billion bail-out of Mexico in 1995.
Michel Camdessus, the IMF's managing director, stated that the overall thrust of the programme was to "transform the risk of a crisis into an opportunity to address underlying problems". He hopes to do this with a three-part programme. The first part of the programme is intended to help Jakarta develop a macroeconomic strategy which will restore confidence to Indonesia's financial markets. The second part involves restructuring Indonesia's financial sector, with measures to make sure it remains sound. The last part of the programme addresses deregulation and trade reforms. The goal is to create more transparency and openness and improve the governance framework and the business climate.
If one looks at the details of the plan, there are some mildly encouraging items. For instance, the Indonesian Government said that it would reduce some import tariffs, end tax breaks for locally produced cars, and rein in trading monopolies for staple foodstuffs. It also promised to gradually reduce export tariffs. In particular, Jakarta announced that imports of wheat, soy beans, and garlic would be freed from a monopolistic import licensing system that had boosted domestic prices.
In addition, the Soeharto government set some demanding economic goals for itself. For instance, it pledged to cut spending to ensure a balanced budget and reduce the current account deficit to below 3 per cent of gross domestic product over the next two years. It plans to increase savings and improve tax collection to achieve a balanced budget for 1997. It also hopes to reach a budget surplus of 1 per cent of GDP in the next fiscal year, despite the impact of the rupiah's depreciation on debt payments and fuel imports.
But how will these goals be achieved? Jakarta has not provided a concomitant national economic strategy that would convince investors that it knows how to reach these lofty goals. Without a clear strategy, for instance, teetering Indonesian businesses have no sense of whether liquidity will ease enough for them to borrow money at lower interest rates.
In addition, the programme has many vague elements, which means that a lot of money could disappear. The vagueness about bank reform in the midst of the ongoing financial turmoil is particularly worrisome to investors. Without clear guidance, money could be wasted propping up badly managed banks. The three-year timetable is also a leisurely pace at a time of policy urgency. It worries investors when it appears that Jakarta can take its time in implementing the reforms.
Meanwhile, Indonesia's neighbours (Singapore, Malaysia, Japan and Australia) have offered an additional US$11 billion financial rescue package to Jakarta. All these countries trade heavily with Indonesia and have long-term investments that they understandably want protected. The good news is that Indonesia has more than enough money to help put its economic house in order if it chooses to spend the money wisely.
The bad news is that President Soeharto has told the IMF and the World Bank that the Asian package offers softer conditions than the IMF/World Bank package. As one Western broker puts it, "the bilateral aid pledges" certainly make the talks (with the IMF) more difficult. I think (Indonesian officials) are using them as leverage to reduce the conditions of the IMF".34 In short, the additional Asian money ironically increases the risk that the IMF money could end up in a black hole.
The Political Challenge
For the IMF plan to be successful, therefore, President Soeharto would somehow have to accept tough conditions. For instance, the government would have to address the root causes of the microeconomic problems. This means reforming a weak banking sector. It would require radical reform of central bank supervision of commercial banks. In addition, widespread cronyism in the corporate sector must be tackled. This means stricter rules to ensure transparency of government contracts and curbs on state and private monopolies.
Jakarta must also think long and hard about its monetary policy. Some people say that the central bank should lower interest rates and not worry about higher corporate debt servicing if the rupiah falls. A "greater national interest would flow from a weaker rupiah that would give Indonesian exports a competitive price advantage". That argument is negated by the high import content of many of Indonesia's manufactured imports. Letting interest rates and the rupiah both fall would threaten the country's macroeconomic stability because the increase in the rupiah prices of imported goods would boost inflationary pressure.
On the other hand, any attempt to restrain these inflationary pressures through higher interest rates would inevitably lead to slower growth and quite possibly a recession. Thus, the BI has the difficult task of finding the right mix of policies aimed at achieving an optimal balance between the twin objectives of financial stability and economic growth.
All this leaves President Soeharto perplexed. In the past, the success of his 32-year regime had depended on delivering solid economic growth. For years, 7 per cent economic growth had been more than enough to outpace population growth in the fourth most populous country in the world. This economic success story had also been enough to fend off any political challenge to his rule. But the day of reckoning for all the years of rapid growth and overborrowing for white elephants has arrived. Financial turmoil has engulfed the country. Economic growth of 7 per cent a year is long gone. It is unlikely that economic growth will reach 5 per cent. It could easily be much worse. And even 5 per cent economic growth would have a devastating impact on job creation.
The IMF is telling President Soeharto that he must abandon the mega-projects and make other radical cuts in the budget if he wants to restore financial stability to the country. Of course, the sharp fall of the rupiah also makes tightening Indonesian fiscal policy more difficult than in the past. This is because many of the government budget items are also imports, which now cost 34 per cent more.
Without radical budget cuts, the budget deficit will balloon, which in turn would make it impossible to lower interest rates without sending the rupiah on another nose-dive. In this regard, Finance Minister Mar'ie Muhammad recently said that the government would face a budget deficit of 9,200 rupiah (US$2.50 billion) by March 1998 unless it made big spending cuts.35 But where should the cuts be made? Senior officials of the ruling Golkar Party have reported that Soeharto's ministers have quarrelled over which of their pet projects would get the axe if the IMF pushes for cuts in state spending. Tension has reached such levels that Research and Technology Minister B.J. Habibie, long a Soeharto protege, is under pressure. His fellow ministers reportedly shouted him down in front of Soeharto at a 10 October Cabinet meeting for insisting that his projects be spared any cuts. Habibie's airplane factory and shipyard have lost billions of U.S. dollars.36
The World Bank has recommended that Indonesia lift subsidies on imported fuels such as diesel and kerosene. According to Bagus Sudjana, Mines and Energy Minister, the currency crisis raised the cost of subsidies on imported fuels to 3,000 billion rupiah, nearly a third more than budgeted for the whole financial year. Thus, if these subsidies are cut budget savings could be substantial. The problem is that reducing the subsidy is good macroeconomics but bad politics, at least in the short run for President Soeharto. This is because 60 per cent of rural households rely on kerosene for energy and lighting and many of them are poor people who would immediately be hurt by such a subsidy cut. The same political backlash occurs whenever the government tries to cut food subsidies. Sharp increases in basic food prices also hurt the poor in the short run.37 In fact, angry students in Jakarta recently demonstrated outside Bulog - the state monopoly that regulates food prices -- demanding the resignation of its director and a price freeze on staple foods.
Despite all the financial hysteria, the turmoil during July and August did not immediately filter down to the man on the Jakarta street. For awhile the financial setbacks were mainly felt in corporate boardrooms in high-rise towers above Jakarta. This is largely because only half a million Indonesians - out of a population of 200 million own shares in the stock market. But things are changing fast. The man on the Jakarta street now feels the pain. Even if the government does nothing to reduce the ever growing budget deficit, Indonesian society at large has already begun to feel some of the inflationary effects of the falling rupiah. Work stoppages have taken place because factory owners no longer know how to calculate their cost and fail to pay wages. This has caused workers to be laid off. In short, inflationary pressure from a falling rupiah is beginning to put political pressure on President Soeharto.
Most experts say that Soeharto and his Golkar Party will maintain ample support in the Consultative Assembly which votes for a new President and Vice-President in the March 1998 elections despite the financial turmoil.38 In addition, General Feisal Tanjung, Chief of the Armed Forces, has indicated that he is prepared to use military force to crack down on any opposition movement that disturbs the elections.
But while President Soeharto is likely to maintain his political power, the currency crisis has seriously undermined his moral authority. Well-run economies do not have to go to the IMF for embarrassing US$23 billion rescue packages. While a full-fledged popular uprising against Soeharto is unlikely, even limited unrest in response to the financial turmoil will be a strong and politically significant challenge to his legitimacy.
The irony is that Indonesian corporations -- whose ineptness at hedging their foreign debt contributed in no small part to the financial turmoil - are beginning to hedge their bets and shield their assets from a possible post-Soeharto government. The Salim Group, Indonesia's largest conglomerate, moved control over US$1 billion worth of equity in a core subsidiary, Indofood Sukses Makmur, to a Singapore-listed company in July.39 This kind of capital flight is not exactly a vote of confidence from business that President Soeharto will weather the storm.
Conclusion
For years the "Asian tigers" experienced extraordinary success in the global economy. They attributed much of that success to stable currencies that were linked to a weak U.S. dollar. That gave their booming exports a price advantage. Then things changed. The Japanese and the Chinese devalued their currencies. Since "tiger" currencies were linked to a rising U.S. dollar, "tiger" exports became much more expensive. This contributed to a slow-down in "tiger" exports in 1996 and a rising current account deficit.
Instead of taking action to correct this imbalance, "tiger" leaders rationalized that the deficit was investment rather than consumption driven and would make their exports more competitive in the future. But actually the so-called investment was unwisely spent on property which could not be exported in the future.
Structural fault-lines also account for the slow-down in export growth. Rising wages outpaced gains in productivity, which priced the "tigers" out of the traditional low-technology export markets. Education is also a problem. Too many "tiger" schools prefer training the memories of their students to regurgitate information rather than educating their minds to think creatively. When these same students graduate and enter the work-place, they lack the skills to move from copy-cat production to more innovative work in problem solving and knowledge-based production.
Years of rote learning and blind obedience to authority have contributed to rigid mindsets and institutional rigidity. This makes constructive criticism, creative new ideas and dynamic change extraordinarily difficult. That was why most of the "tigers" generally clung to currency stability long after it became obvious to outsiders that it was hurting their economies.
In Thailand, for instance, interest rates were raised to maintain currency stability. High interest rates made it difficult to borrow in baht at home. Thai banks made it possible for Thai businessmen to borrow overseas in U.S. dollars at lower interest rates which resulted in a flood of capital inflow. As a result, Thai businessmen piled up huge U.S. dollar debts, much of which was short-term, "hot" money that could leave the country if foreign investors got jittery.
In addition, too much of this foreign money was spent building up an over-capacity in property, redundant manufacturing plants and wasteful white-elephant projects. Before long, bankers began to loan foreign money to reckless businessmen for hare-brained schemes and wild speculation. When it became clear that U.S. dollars were being wasted on foolish investments that could only result in non-performing loans or defaults, investors sold baht assets and bought U.S. dollars. This triggered a run on the baht and the currency crisis in Thailand.
When it became clear that other "tiger" countries were doing much the same thing as Thailand, the currency crisis in Thailand spread to other currencies in Southeast Asia. As "tiger" businessmen watched their currencies fall, their unhedged debt in U.S. dollars became more and more expensive to service. They panicked and frantically sold their currencies.
As the demand for U.S. dollars escalated, central bankers were afraid that they could no longer cover their massive current account deficits without depleting their foreign reserves. The result was a vicious spiral of falling currencies, collapsing stock prices, and growing fears of corporate bankruptcies and banking failures. Eventually Thailand and Indonesia were forced to approach the IMF and other lenders for financial support to weather the storm.
The job of the IMF and the other multilateral agencies is to help boost investor confidence. IMF money helps to stabilize the balance of payments and maintain optimal reserves. But the really difficult policy changes must still be implemented by Thailand and Indonesia. The IMF can and should have tough conditions for continued access to the money. But if Bangkok and Jakarta are unwilling to bite the bullet and implement the policy changes, the IMF cannot force them to make it happen.
The changes that Thailand, Indonesia and Malaysia must make are extraordinarily difficult. To calm investor fears, they must all come up with credible national economic strategies. This means cutting out all white-elephant projects from the budget instead of "postponing" or "reviewing" them. A lean and mean budget will reduce costly and unnecessary imports, thereby reducing the size of the current account deficit and decreasing the size of the capital inflow needed to finance it.
This kind of tight fiscal policy will allow the central banks more elbow-room to lower interest rates without fear of another currency crisis. In fact, their currencies should get stronger once investors see a credible strategy in place and start repurchasing their financial assets again. Stronger Asian currencies will make it cheaper for Asian corporations to pay back their unhedged U.S. dollar loans. And lower interest rates at home will encourage businesses to borrow from the vast pool of national savings at home, thus making central bankers less vulnerable to a reversal in overseas "hot" money.
In addition to these changes in their macroeconomic strategies, "Asian tigers" must attack their microeconomic fault-lines. At the top of the list is bank reform. Commercial bank professionalism and supervision must be improved. This means better disclosure of private bank debt. It also means saying no to white-elephant projects and standing up to the political pressure from politicians. Some of this money freed from profligacious opportunity costs could be rechannelled into rural areas to educate students, and into the cities to retrain workers for up-market production.
None of this will be easy. So far, the "tiger" governments have shown a willingness to make piecemeal changes. But they have demonstrated an unwillingness to develop credible and coherent economic strategies that would attack the root causes of the financial crisis. Until these changes are made, investors will remain jittery about the region and financial turbulence will frustrate economic recovery and political stability.
NOTES
1. When the U.S. dollar rose vis-a-vis the Japanese yen in the mid-1990s, it also lifted the Southeast Asian real trade-weighted exchange rates by 5-8 per cent over a twoyear period. I agree with the Wall Street traders who perceived the Asian currencies to be overvalued. That was why the currencies were attacked. On the other hand, some analysts take a more technical view and disagree with me and Wall Street traders that the Asian currencies were overvalued. For instance, Morris Goldstein
argues that by most technical yardsticks, such as estimates of purchasing-power parities (PPPs, which equate the prices of a basket of goods and services in different countries), most Asian currencies were actually undervalued.
2. The Economist Intelligence Unit (EIU), Country Report: Thailand, 3rd Quarter 1997, p. 36.
3. Ill-advised investment spending on unnecessary capacity is especially dangerous if it is coupled with rapid monetary growth, which tends to inflate an asset-price bubble. Of course, when the bubble ultimately burst, it left Thai banks with huge bad loans on their books. Like Mexico in 1994, Thailand had too much money sloshing around in 1996 and 1997. Financial Times (FT), 29 August 1997.
5. For awhile, the Thai workers simply worked harder than everyone else. Hard work, low wages, weak currencies and substantial capital caused exports to surge. Then things changed. Thailand began to lose its wage and cost advantages in low-tech industries. At the same time, Thai productivity and technological innovation still lags far behind the advanced industrial nations. In fact, labour costs have risen about twice as fast as productivity. In retrospect, it is now clear that the Asian economic miracle was more a reflection of "perspiration, not inspiration". See Paul Krugman, Fortune On-line, 18 August 1997.
6. See Leif Roderick Rosenberger, "The Cultural Challenge for a Concert of Asia", Contemporary Southeast Asia 18, no. 2 (September 1996).
7.Indonesia was an exception. It started as early as 1995 to widen the fluctuation bands for the rupiah against the U.S. dollar. This relative flexibility allowed a gradual depreciation of the rupiah (by some 4-5 per cent per year) to take place, which in turn helped to prevent the emergence of serious exchange rate distortions. 8. Discussions with officials at the Bank for International Settlements, September 1997.
9. EIU, Country Report: Thailand, 3rd Quarter 1997, p. 22.
10. The IMF programme for Thailand contains the following elements: - the reserves would be maintained at a minimum of US$23 billion in 1997 and US$25 billion in 1998, to provide import cover over three months; - monetary policy would be kept tight, not only to control inflation but also to stop the authorities printing money in vain attempts to rescue failing financial and property companies;
- value-added tax (VAT) would rise from 7 to 10 per cent and there would be no
subsidies to prevent utility rates from rising;
- there would be cuts to fiscal spending of lOo billion baht to bring the 1997/98 budget back into balance;
- the government would accept as targets the reduction of the current-account deficit to 5 per cent in 1997 and 3 per cent in 1998; the maintenance of GDP growth at 3-4 per cent; and the capping of year-end inflation at 9.5 per cent in 1997 and 5 per cent in 1998;
- public-sector wage increases would be kept in line with inflation; and - state enterprises would maintain their overall financial balance by cutting back or rephrasing low-priority investments and seeking private-sector participation in infrastructure programmes.
11. The Bank of International Settlement offered to provide a bridging loan worth US$3.3 billion to tide Thailand over the period before the pledged funds were available.
12. Indonesia Times (IT), 4 November 1997.
13. FT, 23 September 1997; and the Economist, 6 September 1997.
14. FT, 28 July, 1997.
15. FT, 29 August 1997.
16. For good background reading on Indonesia, see Hal Hill, The Indonesian Economy since 1996: Southeast Asia's Emerging Giant (Melbourne: Cambridge University Press, 1996); Ross McLeod, ed, Indonesia Assessment 1994: Finance as a Key Sector in Indonesia's Development (Singapore: Institute of Southeast Asian Studies, 1995); and Adam Schwarz, A Nation in Waiting. Indonesia in the 1990s (St Leonards, New South Wales: Allen and Unwin, 1994).
17. See EIU, Country Report: Indonesia, 3rd Quarter, 1997.
18. About 80 per cent of Indonesia's current account is financed by direct foreign investment. See FT, 19 August 1997.
19. FT, 9 October 1997.
20. Business Week International Edition (BWIE), 27 October 1997.
21. Ibid.
22. FT, 19 August 1997.
23. FT, 6 October 1997.
24. FT, 9 Octobe4r 1997.
25. Short-term rates stood at 30 percent in early September 1997.
26. FT, 2 September 1997.
27. Ibid.
28. FT, 4 September 1997.
29. Indonesian Times (IE), 26 September 97.
30. FT, 9 October 1997.
31. Ibid. and BWIE, 20 October 1997.
32. FT, 1 November 1997.
33. Ibid.
34. FT, 30 October 1997.
35. FT, 8 October 1997.
36. BWIE, 27 October 1997.
37. Of course, raising the price of food to its true market value in the short run would also create incentives for local producers to produce more food, thus increasing the food supply, reducing the price of food, and getting rid of food subsidies in the long run.
38. See FT, 8 October 1997.
39. BWIE, 27 October 1997.
LEIF RODERICK ROSENBERGER is Professor of Economics at the U.S. Army War College. He is spending his sabbatical year as a Visiting Scholar in the Economics Department at Harvard University.
Copyright Institute of Southeast Asian Studies Dec 1997