There is no escape from the financial hurricane

Winarno Zain , Jakarta | Tue, 10/14/2008 10:21 AM | Opinion

The debate about why and how the current global financial crisis occurred will continue among financial pundits for years to come. But it is already all too clear that it all started with what the IMF calls "institutional behavior".

The IMF could be more explicit, of course, but everybody knows what they mean. And Indonesia will also suffer immediate impacts from the financial meltdown.

The reckless pursuit of profits and the greed that drove several banks to extend home loans to below-standard customers were demonstrations of blatant disregard of prudential banking practices and risk management. The lax monetary policies that have been going on for years and the lax supervision of financial institutions in the United States have served as a breeding ground for the dreadful financial storm.

Government policies on financial institutions have been based on the conventional wisdom that banks are "too big to fail". As banks deal with money and payments, trust is the bedrock of their existence. If one bank fails, that can shake the foundations of the other banks, undermining confidence in the money market, resulting in bank runs from one bank to another, destroying the national payments system, meaning millions of people could lose their money in seconds. That is why, despite some moral hazards, governments have been forced to rescue failed banks at the taxpayer's expense.

But in capitalist countries, especially in the United States, for ideological reasons, the government is always torn between the need to regulate financial institutions and the preservation of the market mechanism. Backed by rapid progress in information technology, financial products undergo rapid transformation.

Various sophisticated and innovative financial products were created in rapid succession in the past decade. The development was so fast that government regulators themselves have always been several steps behind in understanding the nature and the risk of the new financial products. It is possible therefore, that what the IMF calls "loopholes" were behind the recent financial meltdown.

The whole world is waiting to see what will happen next. The United States, the EU and Japan are adopting different approaches to tackle the crisis. The Americans have decided to use $700 billion to bail out financial institutions by buying their toxic assets. This will take some time, as it is not easy to assign an appropriate value to each asset being acquired.

Sorting out the bureaucratic process is another step that will take time. These uncertainties will not extinguish the fire that is burning up the market.

The stock price index could move into the black, but only temporarily before it gets burned again. The Europeans use nationalization by recapitalizing the failed banks, an approach that is not only close to their ideological inclination but that is more practical and gives greater certainty.

Central banks in several countries have cut interest rates and provided unprecedented liquidity to the market. The U.S. government has decided to buy stakes in banks, an unprecedented move for an ideologically conservative government.

The G7 governments at their meeting agreed on several coordinated steps designed to strengthen the banking system. But the market remains skeptical and confidence remains shaky. Slides in stock prices will continue, and nobody knows when they will hit the bottom.

But what is more important now is to recognize that the world economy is already rolling into a downward spiral and no concerted efforts from various governments will be able to hold back the tide.

First, skyrocketing energy and food prices have eaten into consumers' income.

Second, the disappearance of liquidity from the money market has pushed corporate sectors into the brink. As they are unable to obtain working capital loans for day-to-day payments, they have to stop their operations.

Job losses are mounting. The globalization and the interconnected world economy mean that a contraction in one country will readily spread to other countries.

The threat to the Indonesian economy from the severe economic downturn cannot be underestimated. Exports will be dragged down as demand from industrialized countries and commodity prices tumble. It is not certain how, at this point, the Indonesian macroeconomic fundamentals -- current account surplus, adequate reserve, manageable external debt and fiscal deficits and strong bank balance sheet -- will manage to be sufficiently strong to withstand the impending financial storm.

It is unfortunate that at this critical moment, Bank Indonesia has not finished its battle against higher inflation and has to increase its benchmark rate.

In hindsight, the situation is different from the one at the onset of late 1990s Asian economic crisis. At that time, it was the wholesale collapse of the rupiah, first and foremost, that triggered the crisis.

The fixed exchange rate regime broke down, at a time when -- based on the assumption that the government would defend the rupiah at any cost -- corporate external indebtedness was huge, equal to the government sovereign debt. Under the weight of their corporate clients' bankruptcies, weak oversight and bad management, the Indonesian banking system was in near total collapse.

In the current crisis, although Indonesian banks are not directly exposed to the financial crisis in the United States, they will still suffer from the global credit crunch anyway. Amid the uncertainties, banks are reluctant to extend loans as they face difficulties in getting external funding.

Why would banks lend money to firms whose sales and markets could shrink next month? They would rather preserve their cash to safeguard their liquidity.

"Cash is king" is now the battle cry of the market players. This will make it harder for the businesses and households to get loans. In the midst of a shortage of liquidity, it will be difficult for the government to issue bonds and treasury notes to plug the deficits in its budget.

As businesses -- both big and small -- are finding it hard to get working capital, it is inevitable that they will scale down or even stop their operations entirely. The prospect of job losses and more unemployment cannot be discounted.

The government has already taken some steps to prepare for the worst. At this point, though, it is not clear whether those steps will be enough. But history tells us that in the face of calamity, doing too little too late will only bring on the full wrath of the storm.

The writer is an economist and a columnist.

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