CAPITAL FLOWS IN CRISIS AND THE INTERNATIONAL FINANCIAL INFRASTRUCTURE: AN INDONESIAN VIEW

by J. Soedradjad Djiwandono (*)

 

SOME NOTES ON THE INTERNATIONAL FINANCIAL ARCHITECTURE

The awareness of the need to strengthen international financial system has been going on for sometime now. As I recall, it started with an acknowledgement by pundits and authorities on the close link between the soundness of financial sector and macroeconomic management, which has been manifested in different studies and communiqu‚ or declaration of multilateral gathering. But, the Asian crisis seems to be the driving force of the world to be more focus on what to do about it. Now we have reports from studies by working groups formed by 22 Finance Ministers and Central Bank Governors as well as report of the Managing Director to the Interim Committee, and a hose of papers discussing the issues or advancing proposals to address the problems.

In general the proposals for strengthening the architecture of the international financial system compose of the following areas:

  • Internationally accepted standards
  • Transparency
  • Strengthening financial systems
  • Promoting orderly integration of international financial markets
  • Involving the private sector in the prevention and resolution of financial crisis

Let me touch on these issues in sequence based from my assessment on the Indonesian experience. When one makes an assessment form a distance, in terms of physical or time, one could see things clearer, and tends to be more ready to accept or agree to some proposals or concepts. Of course one has the benefit of hindsight for discussing about something of the past. And it is not too difficult to agree on something in the future about something normative.
I would like to make some assessment about the financial architecture, which is something in the future, at least after the crisis is over. This does not change the fact that for the crisis countries, the most pressing need is for getting out of the crisis itself. Only if the crisis is successfully overcome, or if there is a good prospect to be dealt with successfully, the new financial architecture would be interesting. But, of course, what does it mean, what does it imply, etc. have to be made clear first, before a concrete program could be adopted and implemented.

On the role of internationally accepted standards, the Interim Committee of the Fund reported that progress had been made in formulating codes of good practice for public and private sector entities to be adopted as benchmarks on which countries could be compared. 'Transparency in the financial sector is a golden rule' Mr. Camdessus said. I think everyone accepts this. Both efforts of multilateral institutions as well as individual countries to increase transparency have been widely accepted now. This is encouraging. My only note is that we also have to prepare the public that increasing disclosure would also imply a possibility of an increase in market nervousness, especially if the problems of disclosures are not properly treated. We have been observing that market nervousness could lead to a panicky as a manifestation of the 'herd instinct'.

The private sector involvement in resolving and preventing crises is, I think, becoming very important, at least from the perspective of the Asian experience. I think, there has been some kind of consensus that in the most effected countries the private sector external debts have been one of the major problems causing the crisis. However, what has been the private sector's role in each case has not been very clear. Mr. Camdessus in one of his speeches on the subject acknowledged that this is, in fact, one of the most complex issues of the new agenda for international financial architecture. The Indonesian experience shows how difficult is to come up with a workable scheme to solve the private sector debts' problems. In the beginning, partly because of the IMF position on the issues, the government policy was absence except stating that the government is not going to bail out the private sector that faced problems of default. Only after a long winding process that some formula of the government involvement in addressing the private sector debts problems in the end resulted. But, the problem is far from being clearly identified, let alone solved.

There is one observation that I would like to make here. I have to admit that some views on the problems of private sector debts in the Asian crisis are sometimes confusing. The argument on moral hazard to explain the large exposures of investors in these countries has not been very convincing. If indeed, these investors were pouring money to these countries, assuming that the host countries' governments - and the Fund - would be bailing the debtors out in the event of default, then, if it turned out that there is no bail out, who is to blame? The fact is that their assumption is just not right in the first place. In the case of Indonesia, there has never been any implicit, let alone explicit, guarantee by the government. The reverse expectation is on the deposit guarantee. Some critics argue that the failing of bank closures in Indonesia was because there was no deposit guarantee. I think the private sector involvement in resolving current debt problems as well as finding formula for preventing future crises is very important. The fact that these issues have been recognized is an encouraging development. There is still a long way to go, but a preliminary step has been in the right direction.

Issues on strengthening financial sector have been discussed earlier, and more results have been achieved here. We have to admit that the Fund has been instrumental in creating international awareness about the importance of bank soundness in monetary policy and macro-economic management in general. Beginning with studies on cases of banking crisis in the early nineties, and continued in mid nineties, monetary authorities all over the world were reminded about the issues. The fact that we still have Asian crisis with unsound banking problems at the center of it may only tell us that timeliness is so important. Had these problems were identified sooner and properly addressed, we might not have to experience Asian crises at all.

It had been the Indonesian experience that the unsound banking sector had been constraining the implementation of monetary policies, the working of payment system as well as a strict adherence to prudential measures. It still has to be seen whether a sound banking sector could withstand contagion effects and crises. However, it is almost sure that an economy could withstand currency shock not to become a crisis. It has been well documented that in the past two decades more than two third of IMF member countries, developed as well as developing countries have been experiencing some sort of banking distress or crisis. The Asian crisis has also been dominated by problems of unsound banking sector. These development should be enough to convince monetary authorities and market players all over the world to get really focus in doing everything necessary to have sound banking system as part of economic fundamentals of each national economy.

The issue of liberalization of capital account has been receiving so much attention, in the beginning on how to speed up the process, culminated in the Interim Committee declaration of 1997 in Hongkong to proceed with the mechanism for IMF member countries. However, since the Asian crisis led people to see that short-term capital flows had been prominent in causing the contagion, then there have been more discussions on whether it should not be reconsidered. In the last Interim Committee Communiqu‚ it was phrased in more realistic way, i.e. "The opening of the capital account must be carried out in orderly, gradual and well sequenced manner, keeping its pace in line with the strengthening of countries' ability to sustain its consequences".5 Of course, discussion on the issues is still on, especially since Malaysia introduced capital control recently. My only note with this issue is that once a country chooses a path of liberalization, it is almost impossible to reverse. This is true in capital account liberalization, which in the case of Indonesia was done in the seventies. It is also true in the case of banking sector liberalization. In both cases there are requirements to be made, whether in conjunction with or prior to the liberalization. If you did not do that you will be in trouble. But, how would you do to correct, i.e. to retract the sequence when it was already done? Banking sector liberalization as a means to establish a sound banking sector should be done also in orderly manner. It has to be supported with sound financial infrastructure, including strict regulation and supervision plus good governance. But, if you had not been doing all these adequately, you will be in trouble. The problem is how could we correct this.


CONCLUDING NOTES

Capital flows have been very important for developing countries. Inflows of capital to developing countries in different forms have been instrumental for the host countries to achieve significant economic growth, both through their roles in filling the gap of investment expenditures and domestic savings, as well as facilitating the development of the banking and capital market. However, capital flows also pose new challenges for monetary authorities as well as the market players of the developing countries. There has been a consensus that capital flows, in particular short term's private capital flows, have played a prominent role in causing or exarcebating Asian crisis. Addressing properly issues on capital flows, for the policy makers and market players is very crucial in the world efforts to overcome the crisis and establish a sound international financial infrastructure.

In a global finance, when national markets, small and big, developing and developed, are integrated, all parties have to make effort to enable the system works for the benefits of all. The proposed financial architecture that has been widely discussed is an effort aimed at facilitating that globalized finance. I think, all the ingredients are there for all parties to make their best effort to adopt.

Based from my assessment on what have been unfolding in Indonesia, the followings are some notes relevant for the proposal on international financial architecture:

  1. Some lessons from financial liberalization policies in Indonesia, which was mostly adopted in the late eighties and nineties, are in order. The Indonesian experience underlines the argument that banking liberalization has to be done in co-ordination with the improvement of the financial infrastructure, including strict prudential measures and supervision, adequate disclosure, governance, legal protection and market discipline. Proper sequencing is very good, but different original condition may require different sequence. Furthermore, it is impossible to move backward or to retract once a path of liberalization is adopted.
  2. Lessons from the past crises are still valid here, namely that the sooner the better and the problems are usually worse than expected.6 In the Indonesian experience, an IMF study for Bank Indonesia in 1996 showed the number of problem banks and cost for their restructuring, both were much smaller than the estimated magnitudes in the IMF supported program. Basically, the sooner the problems are identified or recognized and the sooner they are properly addressed, the smaller the cost involved and thus, the better the chances for success.
  3. On banking soundness as a requisite for sustainable monetary policy, I would argue that the Indonesian experience supports the contention. It is even plausible to suggest that the linchpin of the crisis is the weak banking system, which has constrained the monetary authority in conducting monetary policy and banking supervision as well as facilitating payment system. I think the inclusion of banking soundness, as an explicit objective of monetary policy, as argued by Guitian, should be seriously considered.7 However, I cannot help but noting that, even though there has been an increasing awareness of the close link between banking soundness and macro-economic policy, partly to the socialization campaign by the IMF and others, it has not been adequate to prepare monetary authorities and market players in developing countries to cope with the crisis. And this lack of preparation has resulted in devastating impacts, especially in Thailand, South Korea and Indonesia. The sooner must have been the better.
  4. In an effort to create a sound banking system by implementing a program that combine banking restructuring and monetary management, we have to be very cautious about the fact that we are working with different variables in terms of their time frame. Monetary policy deals with variables, which have short time lag, even though it has long term implications. To adopt a tight or lose monetary policy is a short run issue. Furthermore, it deals with macro economic variables. Banking restructuring is, however, a long-term problem. It deals with problems of efficiency, management, supervision, regulation, law enforcement, banking ethics, etc., which are long terms and micro-economic issues. I do not want to imply that because they are long term problems a country has more time to address them. The point I would like to raise is that we have to be extra careful in designing and implementing a program that combines monetary policy and banking reform. They are very closely related, and yet they are problems of different nature.
  5. The Indonesian experience also teaches us that, when public expectation is fragile, the closure of insolvent banks, a must for creating a sound banking system, could have an adverse result. A step, which was originally intended to regain public confidence, resulted in a further loss of it. Liquidation of banks should be done when the economy is not in distress, when public expectation is not fragile. This is, of course, easier said than done. However, it remains true, the sooner the better, and the later the costlier.

Finally, I have to get back to my theme that, right now the major problem is not about the international financial architecture, at least for those countries suffering from the crisis. The first priority is still on how to end the crisis. This is, of course, a topic on its own. For Indonesia, this means that, aside from the food problems, the issues are outside economics and finance. The main problem lies in the capability of the national leadership to establish and maintain political and social stability to facilitate the national efforts for ending the crisis. And, as the Indonesian case showed us, it means dealing with problems of national leadership, politic as well as social problems. Without any resolve in these very pressing problems, it is difficult to address issues on international financial architecture.


(*) Professor of Economics, the University of Indonesia and a Visiting Scholar at the Harvard Institute for International Development (HIID).

5. Communiqu‚ of the Interim Committee of the Board of Governors of the International Monetary Fund, October 4,1998.
6. See, Andrew Sheng, The Crisis of Money in the 21st Century, City University of Hongkong Guest lecture, April 21, 1998.
7. See Manuel Guitian,'Banking Soundness: The Other Dimension of Monetary Policy' in Banking Soundness and Monetary Policy, Charles Enoch and John H.Green, Eds. op.cit. PP 41-62. See also Richard N.Cooper in his comment on Steven Redelet and Jeffrey D.Sachs, 'The East Asian Financial Crisis: Diagnosis, Remedies, Prospects' in Brookings Papers on Economic Activity, 1:1998.

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