However, it has also meant that individual countries may at times be vulnerable to serious external shocks, transmitted through both economic and financial channels. Such shocks may quickly result in a country facing a foreign exchange liquidity crisis, with potential serious consequences for domestic economic stability.

Our experience in this region in particular shows that disruptions and instability in the financial sector can cause a severe loss of confidence. However, the situation in developing countries is often worse because they have only limited options to respond in a timely and effective manner. Developing countries often have limited foreign reserves to buffer any sudden capital reversals.  

The lack of fiscal space to enact counter-cyclical budgetary measures might also create further loss of market confidence that induces further capital reversals. From Indonesia’s perspective, the safety nets should also consider both balance of payment issues and budgetary safety, as these are interlinked.

Balance of payment strength supported by adequate foreign reserves help cushion the impact of rapid capital outflow on their exchange rates and provide liquidity to their domestic banks. Indonesia saw significant falls in the foreign exchange reserves in the period between June 2008 and March 2009.

In the budgetary area, to obtain additional resources, developing countries may pursue market borrowing. But borrowing in an environment of crisis is usually not cost-effective. It could also increase the risk of an unsustainable fiscal position, cause capital market distortions, and lead to an inability to service government debt and, for some countries, an increased possibility of default or an inflationary surge.

Globally, efforts are made to strengthen a country’s foreign reserves against the global liquidity crisis.

Precautionary finance from the IMF in the form of the newly developed flexible credit line (FCL) has been introduced. However, even with the introduction of the FCL, many countries are less keen to utilize it due to the inevitable stigma of dealing with the IMF, both from domestic politics and the market.

Regional arrangement such as ASEAN capital market integration has been developed since early 2000.

It has recently been expanded into the Chiang Mai Initiative Multilateralization (CMIM) with effect from March 2010. The total size of the CMIM is US$120 billion in hard currency based on a single contract to address short-term liquidity difficulties and/or balance of payment difficulties in the region, supplementing global financial arrangement. Although the CMIM is self-managed in nature, it is limited in terms of size and conditionalities, including the link portion with the IMF.

A country relying on international capital market needs a boost in the form of credibility support from both regional cooperation and global arrangement. Unfortunately, during crises, developing countries are perceived by international markets as having higher risk, often without a solid basis and based on ratings that haven’t kept up the pace with the improvements and restructuring of reform-minded developing economies.

For example, even though Indonesia has undertaken significant reforms, enacted sound macroeconomic and fiscal policies, reduced subsidies managing fiscal decentralization, developed sound institutions and demonstrated extraordinary growth at this time of crisis, credit rating agencies have been very slow to significantly re-evaluate Indonesia’s credit rating.

On the other hand, many developing countries that experienced severe contractions did not or insignificantly have ratings changed. This creates a feeling that rating agencies are not using an even-handed approach and are unnecessarily punishing reform-minded developing countries.

Ultimately, questionable patterns in grade issuance undermine a developing country’s efforts to raise much needed cost-effective financing. It is also unfortunate that IMF surveillance does not help improve rating and market perceptions where genuine improvements have been recorded. Assessment linked to IMF surveillance should be as impartial and objective as possible and should capture all improvements or deteriorations for both developed and developing countries alike.

There needs to be a full appreciation of developing country improvements and they must be reflected in upgraded credit rating setting as soon as possible. Any tardiness in the applications of an improved credit rating has significant financial implications for developing countries. There are perceptions from developing countries that IMF surveillance work is often not balanced. For example, the IMF often exerts stronger pressure when giving its analysis on smaller countries but a perception exists that they do not appear to treat developed countries in the same manner.

The first line of defense to reduce vulnerability of countries to external shocks is sound economic and prudential policies. The countries need to build strong national financial safety nets as the first line of defense against the external shocks. The global crisis showed that a number of countries, and in particular several emerging markets, were more resilient to the global financial crisis as a result of prior improvement in economic management.

As a result, these countries were able to provide a more supportive macroeconomic environment by loosening monetary and fiscal policies, allowing the exchange rate to adjust, and providing support to their financial sectors. Self-insurance through the use of foreign reserves provided an important cushion against the impact of the global liquidity shortage on domestic activity in some countries.

Despite these improvements, domestic policy actions proved to be effective with overall financial safety nets if other mechanisms are also strengthened, including swap lines provided by a number of central banks, regional financial arrangements such as the CMIM, multilateral agencies’ support for budget safety and modified multi-country precautionary finance.

Based on the experience, action could be taken to strengthen internal and global financial safety nets. Without the immediate efforts on these matters by the G20 Summit, financial integration could pose very serious risks.


The writer is a lecturer at the Faculty of Economics, Gadjah Mada University, Yogyakarta.

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