DAWN - Business; 15 January, 1998

IMF concedes its recipe backfired
By Masood Haider

NEW YORK, Jan 14: International Monetary Fund's plan to rescue Indonesia from the economic crisis backfired triggering bank crisis that helped set off the financial crisis in much of Asia, a confidential IMF report concedes.

The confidential report revealed in the New York Times on Wednesday describes how political paralysis in Indonesia was compounded by a misjudgment at the IMF's Washington headquarters on how the Indonesian people would react to bank closings.

Instead of inspiring confidence as hoped, the closings pushed Indonesia's banking system to the brink of collapse, sending depositors fleeing even from relatively healthy banks and hastening a further plunge in the country's already battered currency.

The report, according to Times, distributed to IMF members last week, does not imply that 'the IMF bears any responsibility for worsening Indonesia's crisis. It attributes most of the blame to President Suharto's government, which it strongly criticizes for failing to enact promised reforms in exchange for the $40 billion international rescue effort.'

However, following Suharto's meetings with the American Deputy Secretary of Treasury Lawrence Summers, it was agreed that IMF's prescriptions and strategies would be revised when IMF Chief Micel Cammadeus comes to Indonesia next week.

In the meantime IMF officials declined to comment on the report, which came as the agency's Asian remedies have come under increased attack, particularly from political leaders throughout the South Asian region.

In the beleaguered Asian nations, newspapers and television programmes are filled with accusations that the remedies prescribed by the IMF - tight budgets, bank closings, high interest rates- are worsening the pain just when businesses need loans and government funds to avoid mass unemployment and bankruptcies, the NYT said.

IMF and Clinton administration officials say publicly that the only way to truly clean up Asian economies is to dive into market reforms, however painful this may be in the short run. But the Fund's report on Indonesia suggests just how hard it has been for governments and international organizations to turn that philosophy into specific policies and to apply them in the fast-moving Asian crisis.

The IMF's report - the Indonesia Standby Agreement: Review Under the Emergency Financing Procedures - describes how a turning point in the country's financial deterioration came in November, when officials were forced by the IMF to close 16 insolvent banks, including at least one controlled by a son of Suharto.

The IMF's economists thought that bank closings would restore confidence in the rest of the country's banking system, by eliminating the bad apples. Instead, the closings caused panic, the report acknowledges, in language that shows that the IMF hardly expected consequences opposite those it intended.

'These closures, however, far from improving public confidence in the banking system, have instead set off a renewed flight to safety,' the report concluded.

'Indonesians withdrew their money, taking $2 bn out of the banking system and shifting funds out of private banks that they feared would be the next ordered closed. Some of that money was transferred to state-owned banks - institutions that many people here believe guarantee greater safety.

By the end of November, the report says, two-thirds of all the country's banks 'had experienced runs on their deposits.'

The problem grew so critical, the report said, that the Indonesian central bank had to pump money into the private banks 'equivalent to about 5% of GDP over the past two months.'

Indonesia's gross domestic product, a standard measure of economic output, exceeded $200 bn last year.

The harried effort to keep the banking system afloat undermined efforts to deal with the nation's other major problem, the plummeting value of its currency, the report says.

The main mechanism any government or central bank uses to defend a currency's value is to raise interest rates. But pumping more money into a banking system - making the currency more plentiful - is a form of interest-rate reduction. So the central bank quickly found itself torn between two contradictory goals, and careened back and forth between them.

'The situation has led to an uneven monetary policy, in which the central bank has shifted its focus from one objective to another, depending on the one which seemed most pressing,' the report says. This is not the first time an IMF order to close banks resulted in a panic. When some banks were closed early in the Mexican crisis in 1995, depositors reacted by hastily withdrawing their money from many banks, the Times said.

Now that IMF has realised that it's remedies have backfired it plans to rethink and reintroduce new setof proposals to rein in the Indonesia's financial malaise.

Reuters adds from Singapore: Harvard economist Jeffrey Sachs said on Wednesday the International Monetary Fund's (IMF) efforts to reform Asia's stricken economies had worsened the crisis by triggering a banking sector collapse.

He said the Fund's requirement that Thailand, Indonesia and South Korea shut down ailing financial institutions in return for massive IMF-sponsored loans had only intensified the crisis in those countries.

'The credit and banking system has broken down deeply in Thailand, Indonesia and Korea,' Sachs told students and academics in Singapore.

'The banks in these three countries can no longer open letters of credit with international banks,' he said.

This was gradually undermining industry and trade, he charged.

'Unless there is a direct approach to restoring banking services within weeks, the economic decline is going to be calamitous,' he said.

The sharp depreciations of the Thai baht, Indonesian rupiah and Korean won had wiped out banks' capital and contributed to a ferocious credit squeeze, exacerbated by withdrawals of foreign credit and funds, he said.

High interest rates had done little to stabilise currencies amid a deepening loss of investor confidence, he added.