Bangkok's poorly designed capital control rocks stock markets

Friday, December 22, 2006 Vincent Lingga, The Jakarta Post, Jakarta

Thailand's imposition of foreign exchange controls that caused a drop of almost 20 percent in local stock prices and systemic, yet smaller falls in other Asian markets Tuesday, is an example of a well-intentioned, but poorly designed and ill-timed policy.

For Thailand to slam controls on its capital account less than three months after the military coup is certainly counterproductive, especially because the military-appointed government has yet to build up its credibility in the market.

The stock market in Bangkok and other Asian exchanges did rally back Wednesday, recouping most of their losses from the previous day, after the Thai government rescinded the capital controls.

However, the Thai attempt to control capital foreign exchange flows will nevertheless resurrect the debate on the merits and drawbacks of controlling short-term capital inflows.

It was strategic, though, for Indonesian Finance Minister Sri Mulyani Indrawati and Bank Indonesia Governor Burhanuddin Abdullah to immediately and repeatedly reassure the market on Tuesday and Wednesday of Indonesia's strong commitment to upholding its fully open capital account.

Bank Indonesia has issued several regulations to minimize the risks of currency speculation against the rupiah without compromising its open capital account. In 2005, the central bank moved to limit foreign exchange derivative transactions with foreign counterparts against the rupiah to a maximum of US$1 million and to cap dollar purchases in outright forward transactions and swaps at $1 million.

The central bank also imposed a three-month minimum investment hedging period on foreign exchange transactions. This means that investors with underlying investment in Indonesia must keep their funds in the country for at least three months. Hedging transactions subjected to this new regulation include outright forward transactions, swaps and call and put options.

These moves aim to prevent wild volatility of the rupiah by reducing the speculative element in the currency market, by among other things decreasing the inflow of hot money to the country.

The return in droves of foreign portfolio investors to the Asian financial market after the 1997

financial crisis has raised great concern about market vulnerability to boom and bust cycles. Thai authorities have been apprehensive over the steady appreciation of its currency, the baht, and worried about the threat of currency speculation.

The reasons for fully liberalizing capital flows were partly pragmatic, as technological innovations, such as new financial instruments, made it easier to circumvent capital controls.
In Indonesia in particular, controls on foreign exchange flows could be highly problematic and vulnerable to corruption, due to the inadequate institutional capacity and high level of venality within the government bureaucracy.

Most studies have also concluded that liberalizing foreign exchange flows could stimulate growth by reducing distortions and enhancing access to foreign financing, as Thailand and Indonesia have proven with the bullish sentiments in their capital markets.

An open capital account may improve economic performance over the business cycle by encouraging more prudent domestic macroeconomic and financial policies, as well as improving short-term access to financing.

Policymakers in countries such as Indonesia with an open capital account are forced to adopt prudent policies because investors are free to bring their money elsewhere, whereas policymakers in countries with capital controls can pursue less prudent policies without being afraid of facing sudden massive withdrawals of funds, at least in the short run.

The potential long-run benefits of an open capital account must, however, be weighed against immediate costs: a country's vulnerability to global shocks or to sudden changes in investor sentiment. Capital flows are subject to pronounced cycles that may induce boom and bust cycles in production and investment.

One source of vulnerability is a mismatching of maturities or currencies, which makes recipient countries illiquid. Such a severe liquidity shortage makes a system vulnerable to panics, while policymakers' options are severely restricted, as painfully apparent in Indonesia during the height of its financial crisis in early 1998.

With capital controls, a central bank can set both the interest rate and the exchange rate simultaneously, at the cost of limiting capital inflows that could finance productive activity.
The question is do the benefits of liberalizing outweigh the costs?

As Indonesia's experience since the early 1980s have proven, the benefits seem to far exceed the costs.

Chile tried to control short-term (portfolio) capital inflows in 1991 by imposing an unremunerated reserve requirement (URR), first on foreign borrowing (except trade credit) and later on short-term portfolio inflows (foreign currency deposits in commercial banks and potentially speculative foreign direct investment).

The reserve requirement was raised from 20 percent to 30 percent. A minimum stay requirement for direct and portfolio investment from abroad also was imposed.

But these controls seemed to be less-than effective because investors found ways to circumvent the controls. The problems lie mostly in the difficulties in the design and application of capital controls.

Capitalizing on the Hong Kong platform

Friday, December 08, 2006, The Jakarta Post

The Hong Kong Trade Development Council (HKTDC) invited journalists from Australia, Asia and Europe, including The Jakarta Post's Vincent Lingga, to attend the 7th Hong Kong Forum of business associations from around the world. The meeting discussed the future role of Hong Kong amid the astronomical growth of mainland China's economy, which will probably become the second largest in the world within three to four years. Below are his reports.

Its integration into the global supply chain, its strategic location in the center of Asia and its position as the gateway to the world's fourth largest economy, China, have been and will continue to be the main advantages Hong Kong offers investors.

But the fundamentals that will sustain and even increase Hong Kong's role as the leading trading and financial center in Asia, despite the fantastic growth of China's Shenzhen, Shanghai and Beijing, are what senior economist Helen Chan calls the Hong Kong brand.

Ms Chan, with the Hong Kong Finance Secretary's Office, describes the key components of the Hong Kong brand: a strong rule of law, good governance, first class infrastructure and a credible financial services regulatory system.

Hong Kong Trade Development Council (HKTDC) Chairman Peter Woo uses a slightly different term: the Hong Kong Platform.

The recent issuance of the world's largest initial public offering, US$16 billion worth of shares, on the Hong Kong stock exchange is another indicator of Hong Kong's growing global role.

The Hong Kong equity market is the second largest capital market in Asia and the fourth in the world. With a total market capitalization of over $1.5 trillion, it raised $50 billion in the first 10 months of this year alone.

"As of October, 355 mainland Chinese enterprises were listed in Hong Kong, representing one third of the total number of listed companies and 46 percent of the total market capitalization," Financial Secretary Henry Tang told the Hong Kong Forum. In addition, Tang said, Hong Kong also is a leader in asset management, with $580 billion worth of business last year.

Hong Kong's extensive financial and business service cluster is unique in Asia for its breadth, depth, sophistication and mix of international and local firms. This cluster includes private banking, fund management, corporate finance, currency trading, insurance, venture capital finance, direct corporate investment and stock brokerage as well as support services such as legal, accounting, management consulting, executive search, public relations, advertising, communications and information technology support.

"Hong Kong will remain the leading financial and trading center in Asia," says Bramono Dwiedjanto, general manager of the state-owned Bank Negara Indonesia (BNI), which has operated a full branch in Hong Kong since 1962.

Dwiedjanto told The Jakarta Post last week that a number of financial and trading companies had moved their offices to Singapore immediately after the 1997 financial crisis in East Asia. But most of them have returned to Hong Kong due to its advantages.

" I don't think Singapore will ever take over Hong Kong's position," added Dwiedjanto, who worked for two years at the BNI branch in Singapore.

"Our long international business experience and our knowledge of China make us the best partners for foreign companies to do business with or in China, and for mainland Chinese companies to do business with the outside world," said HKTDC Executive Director Fred Lam.
Lam acknowledged that several cities in China have also been developing as major financial and trade centers.

"But it is not a zero-sum game between Hong Kong, Shenzhen, Shanghai or Beijing. They will supplement each other," Lam said.

Hong Kong is thus poised to play a pivotal role in the modernization of the Chinese economy.
There has been lingering concern about the sustainability of China's economic miracle under its one-party authoritarian system.

But almost 30 years after the opening of China's economy to the outside world, and nearly ten years after Hong Kong's reunification with China, their economic integration is proceeding quickly and smoothly. The "one country, two systems" principle has allowed Hong Kong to retain its capitalist economy and its own legal system.

Clusters of industries

Today many manufacturing companies have moved out of Hong Kong in search of lower-cost land and labor, notably to the Pearl River Delta region in southern China. Still, many industries remain active in Hong Kong, operating their local offices as trading companies and business headquarters that support offshore production.

They mastermind and control the production process from their headquarters in Hong Kong, making the most of location advantages and division of labor.

The relocation of Hong Kong's industry should thus be viewed as an expansion of Hong Kong's industrial sector, according to a 2005 study by Sung Yun Wing and Chou Win Lin of the Chinese University of Hong Kong.

Hong Kong is also a favorite base for the Asian regional headquarters and offices of foreign companies.

" As of October, there were almost 4,000 regional headquarters or offices of foreign companies operating in Hong Kong," said Mark Michelson, an associate director of InvestHK, Hong Kong's investment promotion body.

Superb logistics

Hong Kong manufacturers and exporters have increasingly played the role of integrators, matching demand from North America or Europe with sources of supply throughout Asia and beyond.

Hong Kong can fill this need because it is home to a number of dynamic clusters of interrelated industries that draw on common skill bases and can reinforce each other's competitive positions.
This role was described by Michael J. Enright, Edith E. Scott and Ka-mun Chang in their book,

The Greater Pearl River Delta and the Rise of China. A Hong Kong company might help a garment company in the United States design its autumn collection, for example, and then organize purchasing, manufacturing and logistics to get the product onto retail shelves on time, meeting quality and budget specifications.

Hong Kong's infrastructure and real estate development cluster links property and construction groups with engineers, architects, surveyors and interior designers. Its seaport is among the world's busiest and most efficient container ports.

Hong Kong also offers legal expertise in the area of air and maritime regulations and dispute resolution, as well as finance and insurance for air and sea cargo.

Pearl River Delta

One of the regions that has benefited from Hong Kong's position as a financial and trade center is the Pearl River Delta (PRD), one of the most economically dynamic regions on the Chinese mainland.

PRD has developed into a manufacturing center of global importance and one of the world's fastest growing economic regions, thanks largely to the role of Hong Kong as an international financial and supply chain management center.

PRD, Hong Kong and Macao are now known as the Greater Pearl River Delta economic zone.
While Hong Kong, with a population of only seven million, has developed as a leading center for management, coordination, finance, information and business services, PRD, with a population of more than 60 million, has emerged as a manufacturing powerhouse.

"Greater Pearl River Delta, with a $410 billion gross domestic product last year, accounted for one-fifth of China's $2.2 trillion economy," said economist Chan.

The attractiveness of mainland China, especially its southern region, has shifted investor interest from Southeast Asia to Northeast Asia. Hong Kong has gained a bigger share of these investments, at the expense of Singapore, thanks to its infrastructure, clear and transparent rules and regulations, international access and proximity to large markets.

Since the 1997 Asian financial crisis, major international financial service companies have increasingly concentrated their regional activities in Hong Kong.

The emergence of the PRD region has allowed Hong Kong companies to decentralize many activities from Hong Kong into the surrounding areas. PRD thus accounted for the bulk of Hong Kong-mainland China trade, which totaled $265 billion last year.

Hong Kong has cumulatively invested more than $260 billion in the mainland, mostly in manufacturing plants in the PRD region.

"Some 75 percent of the estimated 80,000 factories established in the PRD region since the late 1970s have been owned by Hong Kong companies," said Michelson.

Future role

In this changing environment, Hong Kong firms may move further up the value chain, upgrading their services and assuming more front- and back-end roles, such as contributing to product design and development.

China's participation in the World Trade Organization and the development of industries in the Pearl River Delta region will provide a greater scope for high-value activities linking these industries through Hong Kong to the rest of the world.

These developments will also provide additional opportunities for foreign investment and the location of management activities for a wider range of multinational companies in Hong Kong. Hence, Hong Kong is positioned to perform high value-added managerial, financial, coordination and information activities across more industries.

"High-technology, research and development activities should be the next dimension of our economy to make Hong Kong not only the trade and financial but also the technology center in Asia," HKTDC Chairman Peter Woo said at the Hong Kong Forum last week.

Hong Kong's economy will likely grow to look more like those of other major cities in developed countries such as Tokyo, New York and London. These global centers thrive on handling flows of knowledge, information, goods and finance, acting as the nodes at which economic activities are managed and financed.

Agricultural revitalization key to cutting poverty

Monday, December 11, 2006 Vincent Lingga, The Jakarta Post, Jakarta

The findings of the latest World Bank study to the effect that almost 70 percent of the poor in Indonesia live in rural areas and 64 percent work in agriculture boil down to a central message: the fight against poverty should be waged mainly on the rural front.

This does not, however, mean that the focus should be entirely on agriculture as rural non-farm economic activities (micro and small enterprises) also play an increasingly important role as sources of livelihood for villagers.

Although agriculture's contribution to national gross domestic product has declined to less than 20 percent, its direct and indirect contributions to the national economy remain significant through its forward and backward production, distribution and consumption linkages.
Put another way, the agricultural growth multiplier quantifies the impact of an increase in income in the agricultural sector on income growth in other sectors.

However, despite the vital role of agriculture in poverty alleviation, it is quite difficult to see how the Agricultural Revitalization Program of President Susilo Bambang Yudhoyono, launched in July 2005, connects with the new poverty reduction strategy -- the Community Empowerment Program -- that Coordinating Minister for People's Welfare Aburizal Bakrie described at a national poverty conference here last week.

Disappointingly, not a single minister, not even the agriculture minister, has elaborated on the agriculture-revitalization concept after its introduction by Aburizal Bakrie, the then coordinating minister for the economy, almost 18 months ago.

The World Bank report Making the new Indonesia work for the Poor, which was launched last week, reemphasized the vital need for higher productivity in the agriculture sector and rural non-farm small enterprises.

The report endorses the conclusions of similar studies by other domestic and foreign institutions, which have concluded that farmers' incomes can no longer be improved significantly by focusing on such staple crops as rice, cassava, soybean, sugar and corn as such crops will do little to provide additional employment and income growth due to diminishing productivity gains, especially in Java, where most farmers till less than half a hectare.

The problem, though, is that shifting to higher value agricultural activities, such as forestry and horticulture requires high-yield seeds, agriculture extension services, better infrastructure (such as rural roads), up-to-date information flows, market facilities and electricity.
Rural infrastructure is quite vital as in both agriculture and the rural non-farm economy, opportunities for growth can be generated by greater linkages with the urban economy and export markets.

Future agricultural growth will depend largely on urban and international demand for high value agricultural produce. In other words, smooth transportation is vital to facilitating linkages with the farm economy and stimulating the development of rural small enterprises.

The sad reality, however, is that farmers' access to basic services and markets has sharply deteriorated as the result of an acute lack of maintenance of the rural road network since 1998. Likewise, the scope and extent of agriculture extension services has declined since decentralization.

No wonder, agricultural total factor productivity has declined steadily since 1993, according to the World Bank report.

Regional administrations, which under local autonomy play a key role in the provision of both basic services and rural infrastructure, often do not understand the nature and importance of linkages between agriculture and the non-farm economy.

There is nothing wrong with the Community Empowerment Program concept. It will be more effective as it promotes the empowerment and involvement of poor people in conceiving programs, as well as transparent budgeting rules, processes and procedures, good-governance practices and increased accountability.

The program, however, will be less effective in alleviating poverty if it is not supported by strong and competent institutions, and an enabling environment for the revitalization of agriculture and the development of agribusiness in its broadest sense. Yet more challenging is that fact that the responsibility for creating such an enabling climate rests squarely with local government.

The message that one can really draw from the main recommendations of the World Bank study is that poverty alleviation should incorporate the broad objective of empowering farmers (improving their incomes) and the rural community through the development of the farm and non-farm economy, the improvement of rural infrastructure and the provision of basic services.

The revitalization of the agricultural sector will require tight ministerial coordination and cooperation with local administrations in mobilizing resources for the development of such basic infrastructure as roads, markets, processing facilities, rural financial institutions, farm research stations designed to meet area-specific conditions, and technical farm extension services.

The agriculture extension service should be decentralized and be complemented by a conducive business environment to stimulate private investment in the propagation of high-yield seeds for high value crops.

The questions now are twofold: how will the revitalization of the agriculture sector be integrated into the Community Empowerment Program, and which minister will be responsible for coordinating the government functions in all of the multidimensional activities involved in the Community Empowerment Program? Will it be the coordinating minister for people's welfare, Aburizal Bakrie, or the chief economics minister, Boediono?

Advancing beyond macroeconomic stability

Tuesday, October 17, 2006 Vincent Lingga, The Jakarta Post, Jakarta

This is the second in a series of articles The Jakarta Post will publish to mark President Susilo Bambang Yudhoyono's second anniversary in office on Oct. 20. The first article appeared Monday.

Almost two years into his five-year term and President Susilo Bambang Yudhoyono has yet to fully utilize his strong political mandate to transform the country's macroeconomic stability into improved living standards.

Macroeconomic downside risks have been reduced, fiscal management improved with a sustainable deficit and the government debt-to-GDP ratio halved to below 50 percent.
Macroeconomic stability has strengthened but the economy remains vulnerable to shifts in investor sentiment and occasional asset market volatility, because the bulk of foreign capital inflows consist of short-term, portfolio capital, which can fly out at the slightest sign of policy inconsistency.

The financial sector's performance has improved, though the largest two state-owned banks, Bank Mandiri and Bank BNI, remain fragile due to mountains of bad loans. Gross international reserves have increased markedly to enable the government to amortize all its debts to the International Monetary Fund four years ahead of maturity.

Exports have reached all-time records, expanding by over 17 percent in the first eight months of this year. However, most of this gain should be attributed to luck, as the increase was generated mainly by steep price rises in primary commodities such as palm oil, rubber, coal and oil, not by any improved economic competitiveness on the part of Indonesia.

Different from previous presidents, who were often associated with the abuse of power and rampant corruption, Yudhoyono still presents himself as an honest, hard working person with a great deal of integrity.

But his legitimacy and impeccable integrity will not mean much as people lose patience with his indecisiveness on badly needed reforms to reinvigorate the economy and create jobs.
The President failed to take advantage of his strong mandate and push through significant reforms at the start of his term. And he has failed miserably in the sector most meaningful to the majority of the people -- job creation. Unemployment has instead risen.

Poverty increased by 11.25 percent, or 3.95 million people, to almost 40 million people or 17.75 percent of the total population between February 2005 and March 2006, due to the devastating impact of the doubling of fuel prices in October 2005. This poverty incidence, though lower than that between 1998 and 2002, was the highest since 2003.

We don't mean to say the fuel policy was wrong. It should instead be praised as the boldest measure yet taken by the Yudhoyono government to strengthen the foundations of the economy. Its negative impact should be blamed on a poorly designed social safety net and anti-inflation measures.

Open unemployment and underemployment have reached as high as 40 percent of the 105 million total workforce because of persistently moderate economic growth (below 6 percent) amid an acute lack of new investment. Indonesia has failed to rejoin Asia's club of high-growth countries.

While the pace of economic reform announcements has been much slower than expected, the implementation of policy reforms is even more disappointing. The cascading impact of these problems is a disappointingly slow recovery of public and private investments.

Yet more worrisome is the trend whereby each percentage point of growth now generates fewer jobs in the formal sector than it did before the 1997 economic crisis, because of what most analysts see as the impact of too rigid labor regulations.

Things will not likely improve much in this labor market because the government has succumbed to demands of trade unions who oppose the amendments to the 2003 Labor Law, even though they represent no more than 5 percent of the total workforce.

The government apparently does not realize that in the long term, companies, workers and society as a whole will benefit from a more flexible labor market where workers have an incentive to invest in their own social capital and lifelong learning in the competition for better jobs.

Worse still, another set of important economic laws regarding taxation and investment, already several years behind schedule, will most likely suffer another delay. The only small consolation is the new customs law, which is scheduled to be approved by the House of Representatives tomorrow (Oct. 18).

The Infrastructure Summit held last November to woo new investment fell flat due to uncertainty about legal frameworks and lack of clear-cut provisions on government-private sector partnership and risk management. The second Infrastructure Summit, scheduled for next month, does not seem very promising either because of the delay in the formulation of a more conducive regulatory environment.

Promises and symbolic moves, though needed, are not enough to maintain the momentum of market confidence. The market requires concrete measures because only consistent and effective implementation will give credibility to government policies.

As long as the President remains hesitant to assert stronger political leadership to push through key reform measures and vital infrastructure projects, the pace of new investment will remain slow and the economy will continue to muddle through, unable to generate enough jobs for the unemployed and new entrants to the labor market, and lift the 40 million up from poverty.

However we define it, the high rates of unemployment and absolute poverty mean that our economy is languishing in critical condition. And a crisis requires strong political leadership and a fast, credible decision-making system.

Global economic imbalances raise risks of hard landing

Tuesday, September 26, 2006 Vincent Lingga, The Jakarta Post

The 2006 Global Meeting of the Emerging Markets Forum (EMF) here last week warned that the risks of a hard landing for the global economy had increased with the United States continuing its profligate spending amid steadily rising oil prices.

The EMF, an independent not-for-profit initiative of the Washington-based strategic advisory company, Centennial Group, sounded more pessimistic than the International Monetary Fund, which still foresaw a higher probability of a gradual, orderly adjustment of the American dollar.

Panelists and discussants at the EMF meeting, including several former senior executives of the International Monetary Fund and the World Bank, were worried that the U.S. current account imbalance is likely to worsen further. They said the adjustment process was being made even more difficult as a result of the combined impact of the steep hikes in oil prices and the decline in the propensity of net oil exporters to import from the U.S and to invest in dollar assets.

While oil exporters, notably in the Middle East, are together accumulating US$1 billion in a net current account surplus every day, it is estimated that the U.S. will book a $900 billion deficit this year, as against $800 billion last year.

The U.S. has often been warned that its excessive consumption is dangerous for both itself and the world economy, but so far Americans have ignored such doom-mongering, increasing the risks of a hard landing for the global financial market.

As long as American and foreign central banks, notably those in Asia, are locked in a codependent relationship, the U.S. will likely continue its spending spree. According to the latest estimates by the IMF, more than half of all publicly available U.S. Treasury bonds are now held abroad, notably by central banks in Asia. These banks are thus trapped in something of a vicious circle.

Even though the IMF also recognizes some downside risks, it asserts in its 2006 Global Financial Stability Report, which was issued in Singapore last week, that "the structural strength of the U.S. financial market has no doubt enhanced the scale and sustainability of the U.S. current account deficit. The continuing confidence of international investors in U.S. markets supports the prospects of orderly adjustment in current imbalances."

The World Bank estimates that roughly 70 percent of global foreign reserves are now in dollars, making them highly vulnerable to currency correction. An abrupt change in the dollar value could spell trouble, as central banks find themselves with black holes in their portfolios.

Obviously this is neither healthy nor sustainable in the long run. But will the political will emerge to correct the imbalances?

This is unlikely in the near future. It seems that it will be extremely difficult to reach a global consensus to address these global imbalances. There seems to be a mood of complacency given that the markets have thus far been prepared to absorb the imbalances.

The natural adjustment mechanism for America's rapidly growing foreign liabilities should theoretically be a declining dollar, which would lower demand for imports and make America's exports more attractive on foreign markets. But the Asian central banks have been stalling this process as they want to keep their currencies from appreciating against the dollar, and are thus buying sackloads of dollars.

The pressures on the U.S. to get is fiscal house in order by cutting its budget deficit and encouraging American consumers to save are not enough. Too steep a fall in American consumption could instead threaten the world economy with a deep recession. This is because it is the spending binge in the U.S. that has absorbed a steady stream of exports and capital inflows from Asia and other emerging markets.

Hence, reform policies should be implemented to foster the necessary adjustments in saving and investment imbalances, especially in countries that are the main counterparts to the global current account imbalances, notably the U.S., China, Japan, Germany.

There is another factor that has increased the risks of a hard landing for the global economy and made it more urgent and imperative to intensify multilateral consultations so as to achieve a global consensus on ways to correct the global imbalances.

Besides the declining propensity of sovereign Arab oil exporters to invest in U.S. assets and the diversification of their portfolio investments away from dollar assets, the increasing accumulation of petro-dollars by private oil exporters is posing another threat to global financial stability.

This development is shifting the institutional management of an increasing amount of money around the world from central banks in Asia, which hold huge foreign reserves in dollars, to private oil exporters. While central banks are more conservative and constrained in their investment choices (they usually prefer U.S. Treasuries), private oil exporters are entirely free to invest wherever they choose.

The change in the investment behavior of oil exporters, which have been accumulating huge surpluses, could change the pattern of global capital flows at the expense of an orderly adjustment of the global imbalances.

The IMF seems to be the most technically competent body to keep monitoring and analyzing the investment behavior of sovereign and private oil exporters, and to ring the alarm bell whenever necessary. But this institution needs to be given the instruments it requires to strengthen its multilateral surveillance.

WB needs to wean itself off 'nanny' bank role

Thursday, September 21, 2006 Vincent Lingga, The Jakarta Post, Jakarta

The World Bank is an easy target for attacks from all sides given the conflicting demands of its 184 member countries. The bank is mostly active in developing countries, which make up the majority of its members, but its decision and policy-making is controlled by the few developed countries who make up the majority of shareholders.

The perception that the bank merely purveys the policies of developed countries, especially the United States, is therefore unavoidable. This notion is reinforced by the fact that it, together with the International Monetary Fund, is headquartered in Washington and that the U.S. has the privilege of appointing the bank's president.

The bank is under tremendous pressure. Most civil society organizations assail it for what they see as its failure to reduce poverty in the poor countries.

Developed countries criticize the bank for not using its leverage as a lender forcefully enough to obtain meaningful reform in the developing world.

The internal reforms the bank started making in the early 1990s by decentralizing, relocating its decision-making process to the country level, were apparently not fast enough to satisfy developing countries.
Indonesian Finance Minister Sri Mulyani Indrawati expressed the view of most other developing countries when she criticized the World Bank for often acting as a preacher, rather than a partner for developing countries.

Indeed, with annual lending resources of US$20 billion and the largest pool of development thinkers any single organization in the world has ever possessed, the bank's executives, many of whom are from developed countries, often face a strong temptation to act as arrogant advisers.

The bank, with over 10,000 well-paid professionals, commands a brain trust with a huge pool of broad-ranging knowledge and experience on the full range of technical and economic issues of development. Its experts possess the wealth of real-life development experience that the bank's lending operations have generated.

The bank started decentralizing its decision-making by appointing country directors who had the kind of power over budgets and projects that used to exist only at headquarters. But the results were seemingly far below expectations.

It was this slow-paced decentralization Sri Mulyani appeared to refer to when she noted at the World Bank-International Monetary Fund Meetings in Singapore on Tuesday that the World Bank should change the way it works on the front line.

The bank needs to strengthen its decentralization policy because it needs country-specific knowledge and expertise to help develop local institutions tailored to local political and social realities.

The country director in each member country therefore must have political savvy and be sensitive to a country's political constraints and to the opportunities of responsible leaders to push reform. That implies a premium on systematic analysis of local politics and institutions.

Under the rubric of country ownership, the bank has tried to tailor its lending policies so that clients have more say in their design.

The emphasis on local politics and institutions is crucial because institutional capacity, the quality of governance and the commitment to development differ widely from one country to another in the developing world. The bank's approach should take these differences into account.

The emphasis on local institutions and local ownership of policies, which was reasserted by the World Bank-IMF Development Committee (the highest policy-making body) in Singapore, was aimed at building respect for and partnership with local efforts by the bank staff.

As a Washington-based independent think tank, the Center for Global Development, suggested in a recent report, "the Bank should become less of a nanny bank, preoccupied with detailed conditionality and structural reforms. It should instead concentrate more on supporting healthy local economic and political institutions."

However, local political ownership is not necessarily conducive to equitable growth, as can clearly be seen in Indonesia under the authoritarian Soeharto administration. The World Bank, instead of forcing reform on Indonesia, fully supported the economic policies of the Soeharto government for more than 30 years and condoned its corrupt system.

The bank's effectiveness then depends on how it manages its lending operations in order to support policy reforms and development result.

IMF reforming its decision-making mechanism

Wednesday, September 20, 2006 Vincent Lingga, The Jakarta Post, Jakarta

The International Monetary Fund took a major step Monday toward improving its acceptance and credibility among developing countries by adopting a package of reforms on quotas and voice in the IMF, with respect to its decision- and policy-making powers and the reshaping of its surveillance foundations.

These reforms are the first step in a long process that will increase the representation of many developing countries to reflect their rise in the global economy. Right away, the resolution of the IMF board of governors will increase the voting power of four countries -- China, Korea, Mexico, and Turkey -- that are most clearly underrepresented.

Equally important is that the board of governors has agreed the IMF must strengthen the voice and representation of poor countries that continue to borrow from the IMF but only have a limited share in IMF voting.

The reforms will improve legitimacy, in terms of how IMF governance is structured and how that is perceived among developing countries, which have long complained about what they see as the grossly unfair control of the IMF by developed countries.

Experience has shown it is not enough for the IMF, and its Bretton Woods sister -- the World Bank -- for that matter to prescribe the right policy advice. This advice is more likely to be accepted if it comes from an institution that is seen as representative of the interests of developing countries, which make up the majority of members and borrowers from the IMF.

The reforms just adopted by the highest policy -making body of the IMF will go along way toward improving IMF acceptance and credibility. The IMF's credibility will continue to be undermined if the monopolistic behavior of large countries with veto power is not checked.

Still encouraging is that more reforms are in the pipeline as the board of governors also has ordered the IMF executive board to reach an agreement on a new quota formula to guide the assessment of the adequacy of members' quotas in the IMF. Such a formula should provide a simpler and more transparent means of capturing members' relative positions in the world economy.

The present IMF quotas have been seen by most members as a distorted mirror of today's economy because they must do three things at once: They determine how many votes a member can cast on the board, how much money a country must put into the IMF coffers, and how many dollars a country can take out before attracting penalty interest rates. As a result, many countries are now underrepresented.

The reforms are implemented at a time when the IMF's popularity is at its nadir and its budget is shrinking because many of its best customers are now doing without it.

What then are the jobs of the IMF? Apart from generating mountains of analyses, the IMF's function is to inject foreign exchange in countries that have temporarily run short. But lately no one has been calling on its reserves. Brazil and Argentina have both repaid their debts. Even Indonesia has paid in advance half its $7.8 billion debts and plans to amortize the remainder later this year. Hence, now only Turkey still owes a significant amount of money to the IMF.

With no way of treating members in financial crisis with what "patients see as bitter pills", the IMF is left only with the power of surveillance, keeping an eye on the policies and frailties of its members. But even this surveillance role has increasingly been detested in many countries, especially in Asia.

But the fact is that, like it or not, the IMF's role as an emergency lender is still relevant, at least until regional financial cooperation can be expanded through reserve pooling. After all the IMF can immediately call on about $220 billion of hard currency if needed to help countries in financial distress.

True, South Korea, Japan, Singapore, Indonesia, China, Malaysia, the Philippines and Thailand, which together command international reserves worth 10 times the IMF total, have begun pooling a small fraction of their resources under an initiative launched in Chiang Mai in 2000. But this regional arrangement has yet to be tested.

If emerging economies want to insure themselves against financial crisis it would not be cost efficient to set up their own "safety net" to make emergency lending available. But how can the IMF, as an emergency lender to all countries, regain the confidence of its estranged members.

That is the main objective of the package of reforms adopted by the IMF board of governors at its annual meetings in Singapore.