«Debt Composition and Balance Sheet Eﬀect of Currency Crisis in Indonesia Agustinus Prasetyantoko To cite this version: Agustinus Prasetyantoko. ...»
Debt Composition and Balance Sheet Eﬀect of Currency
Crisis in Indonesia
To cite this version:
Agustinus Prasetyantoko. Debt Composition and Balance Sheet Eﬀect of Currency Crisis in
Indonesia. The Japan Economic Policy Association 5th International Conference, Dec 2006,
Tokyo, Japan. 2006. halshs-00134223
HAL Id: halshs-00134223
Submitted on 1 Mar 2007
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e Debt Composition and Balance Sheet Effect Of Currency Crisis in Indonesia1 Prepared by Agustinus PRASETYANTOKO PhD Student in Economics, ENS – LSH, Lyon Member of GATE – CNRS UMR 5824 15 parvis René-Descartes, BP 7000 69342 Lyon cedex 07 France Email: email@example.com First version: August 2006
Keyword: maturity mismatch, firm investment, balance sheet effect, financial crisis JEL Classification: D92, E32, G32 Paper was presented in The Japan Economic Policy Association 5th International Conference”, Aoyama Gakuin University, Tokyo, JAPAN. December 2-3, 2006 I. Introduction The question of how such huge crisis happened in a fairly good macro economic performance in around Asian countries is still vibrant. Nowadays, it is widely accepted that the real problem of most Asian countries were not really on macro side, but in micro one. Krugman (1999) argue that by normal criteria, government budgets in around Asian countries were in good shape; current account deficits were large in Thailand and Malaysia, but relatively moderate in Korea and Indonesia; despite some slowdown in growth in 1996, there was not a strong case that any of the countries needed a devaluation for competitive or macroeconomic reasons.
The role of micro sector on the macro economic fragility becomes a prevalent analysis in the studies of crisis following a series of financial turmoil in around the world2. By employing the balance-sheet approach we can describe the impact of disturbances on the assets, liabilities and net worth of households, firms, government, and the economy as a whole and on the implications for growth and stability. Balance-sheet approach considers the micro side in explaining the macro fragility. It is indispensable to link micro sectors and macro economic performance.
For the case of Asian countries, there are several arguments behind the macro economic stability. The first is that underneath the apparent soundness of macroeconomic policy was a large, hidden subsidy to investment via implicit government guarantees to banks, cronies of politicians, etc (Krugman 1999). The apparent soundness of budgetary and macroeconomic policy was an illusion: under the surface, the governments were actually engaged in reckless and unsustainable spending. Meanwhile, Corsetti, Pesenti, and Roubini (1998) describe that implicit guarantees led banks to engage in moral hazard lending; it represented a hidden government budget deficit, and the unfunded liabilities of these banks represented a hidden government debt.
This paper intends to translate the balance sheet approach by bringing the empirical evidence on the relation of firm-level investment and the currency mismatch. The main question is whether firms with higher debts in foreign currency have less investment when the currency depreciation is present. We consider that the deterioration of firm balance sheets played a key role in the economic performance.
In the decade of 1990s, waves of crisis hit regions around the world: the collapse of western European’s Exchange Rate Mechanism in the fall of 1992, the collapse of the Mexican country in the winter 1994 -1995, and the East Asian countries in the mid of 1997-1998 There are two channels where firm-level performance will be undermined by currency depreciation. First, firms with high leverage in foreign currency will have low marginal propensity to import. Second large foreign currency debt with low revenue from export activities will reduce the net-worth of the firms. In short world, debt composition of the firms plays important role in propagating crisis.
In Indonesia, the 1997 currency depreciation is associated with poor performance due to unsound capital structures, where firms depend excessively on short-term bank loans to finance their longer-term projects. It bears the maturity mismatch. Meanwhile, the crisis reveals the vulnerabilities of using un-hedged short-term foreign currency borrowings to finance domestic investment projects. In latter case, the currency mismatch is present.
To investigate the effect of currency depreciation on the firm-level investment, this paper links directly the interaction of currency depreciation, debt composition and firm-level investment by using listed companies in Jakarta Stock Exchange (JSX). According to the maturity-mismatch hypothesis, firms with higher exposure in dollar debt should suffer more from the aggregate capital outflow. The main question of this paper is whether firms with higher dollar debt maturity have less investment due to currency depreciation in Indonesia. We use the standard reduced-form investment model to investigate the relation of the currency mismatch and firm-level investment. In this study we include 226 firms listed in the JSX in the period of 1994 –
2004. Panel data analysis is employed in this study.
II. Theoretical Overview
1. Balance Sheet Approach Balance sheet approach focuses on the differences in the values of the foreign currency denominated assets and liabilities on the balance sheets of households, firms, the government and the economy as a whole. For a firm, the currency mismatch derives from the relationship between net foreign-currency denominated liabilities and the net present value of domestic-currency denominated cash flow. A firm with a currency mismatch will experience an adverse balancesheet effect if exchange-rate depreciation raises the value of its net foreign-currency denominated liabilities relative to the net present value of its cash flow.
Following a series of crisis around the world balance sheet approach is considered as an appropriate tool of analysis. Huge research agenda employ this approach.
Some studies focus on the net worth effects of shocks to the exchange rate in the presence of foreign currency denominated liabilities. Others look at liquidity or interest rate shocks when the tenor of a bank, firm or country’s liabilities is shorter than the tenor of its assets. In some studies the propagation mechanism is the impact on consumption and investment of the change in net worth of households and non-financial firms. In others it is the impact on the liquidity and solvency of financial institutions and markets and hence on confidence in the financial system. In still others it is the impact on the sustainability of the public debt3.
In conventional explanation, currency depreciation could enhance firm performance for tradable sector or sector which gains revenues in foreign currency for their production and sales activities. It is a “competitiveness effect” of the currency depreciation. But, in the case of firms highly indebted on the foreign liabilities, depreciation decreases net worth of the firms through “balance sheet effect”. In this channel, firms with high foreign leverages should be suffering more in the case of the presence of currency depreciation. Due to financial globalization and currency fluctuation, firm financing policies contribute significantly on firm vulnerability.
The concern of this paper is actually on the choice of the financial structure of the firms and their impact on the firm investment around currency depreciation in Indonesia. To investigate the effect of currency depreciation on the firm-level investment behaviour, we link directly the debt composition of the firms and the level of investment. According to the maturity-mismatch hypothesis, firms with higher exposure in short-term debt should suffer more from the aggregate currency depreciation. Meanwhile, currency-mismatch hypothesis describe that firms with higher dollar debt should less investment after interaction with currency depreciation.
In most developing countries, excessive external debt of the corporate sector is due to the bank-dependency of the financing policies, which coincides with the weaknesses of the financial sector supervision and governance. In many Asian countries bank commonly offer credit more exclusively for the connected corporate sector. In Indonesia, at the onset of crisis, the credit approval is actually based on two principal reasons. For private banks, loan is preferably channelled to the related firms in the same groups or conglomerate. And for state banks, the relation revealed the memo-credit behaviour that means credit would be disbursed as if any references from high level of government officers or important political leaders. Banking and financial sector are actually lack of the good governance in the well-design institution arrangement. One of the implications is the absence of the risk assessment in the credit approval.
Quoted from Eichengreen, Hausmann and Panizza (2005)
Firms with heavy short-term foreign currency-denominated debt become vulnerable to both exchange rate and interest rate shocks through currency and maturity mismatches. Bernanke, Gertler, and Gilchrist, (1999) explain that the soaring of interest rate can lead to a rollover risk and a decline in the net worth of the firms with higher short term debt magnifying the conventional interest rate channel as postulated by the financial accelerator mechanism.
In the so-called third generation crisis models, currency composition as well as maturity debt becomes a central problem, which could exacerbate the currency crisis. As noted by IMF (2005) “both currency and maturity mismatches can exacerbate the impact of exogenous shocks in emerging markets, increase the severity of crises, and slow down the post crisis adjustment”.
One of the most important consequences of the financial crisis is the investment behaviour in firm level, which induces directly the economic growth. Froot, Sharfstein, and Stein (1993) develop a model in which the cost of financial distress is the loss of investment opportunities.
Many studies provide empirical evidence that maturity mismatch in emerging countries become one of the most important factor inducing financial fragility that ended by financial crisis.
Before the period of crisis in Asia, most countries in the region preferred to employ external short-term debt, which become a problem when the depreciation of local currencies were present.
Most of companies could no repay their debt, and many among them have to reduce their investment level if not liquidate. Since this phenomenon was common, on the aggregate level, economies become more fragile since the investment was collapse that coincided with the reversal of capital account.
Radelet and Sachs (1998) mention this condition as the financial panic where the liquidity holder preferred to move their investment into other currencies. However herd behaviour of the liquidity holders revealed the financial panic is sourced by the fundamental weaknesses of the economy. Corporate sector, which was highly leveraged become one of the source of the fundamental weakness, particularly that much of this indebtedness was at the short term.
Although this risk is microeconomic in nature, the evidence advanced thus far has taken the form of macro correlations (Bleakley and Cowan 2003). Firstly, this microeconomic risk will exacerbate the currency depreciation by considering the behaviour of financial panic and secondly this capital account reversal commonly would be accompanied with a decline in investment.
Several researches are concern on the issue of the balance sheet effects of the exchange rate depreciation. Aguiar (2002) using large listed firms in Mexico describe that there is a balance sheet effect mechanism. It is found that dollar debt and firm investment have significant negative correlation, which means that firms with higher dollar debt have smaller investment due to currency depreciation. Allayanis et al. (2003) find the same finding that firms with higher dollar debt invest less in depreciation period for the case of large listed companies in Asian countries (Hong Kong, South Korea, Indonesia, Philippines, Malaysia, Thailand and Taiwan). Bonomo et al. (2003) using large listed companies also find the same findings for the case of Brazil. Pratap et al. (2003) find the negative and significant relation of the dollar debt and firm-level investment in the case of Mexico.