IMF PROGRAMS, FINANCIAL AND REAL SECTOR PERFORMANCE, AND THE ASIAN CRISIS
Ali M. Kutana,b,c, Gulnur Muradoglub,d, Brasukra G. Sudjanae
aDepartment of Economics and Finance, Southern Illinois University Edwardsville, USA
bThe Emerging Markets Group, Cass Business School, City University London, UK
cThe William Davidson Institute, Michigan, USA
dCass Business School, City University London, UK
e BritishEmbassy and UK Department for International Development, Jakarta, Indonesia Abstract
This paper provides comprehensive evidence on the impact of IMF-related announcements on returns in both the financial and real stock sectors in Indonesia during the Asian crisis. We find that favorable IMF policy news and IMF-related news increase financial sector returns, while they have a rather mixed impact on real sector returns. On the other hand, unfavorable IMF-related events tend have a lesser effect on both sectors than favorable news. The results suggest that during the Asian crisis IMF-related news affected the financial sector more than the real sector and IMF actions hence did not turn a financial crisis into a real crisis. Another important finding is that a negative reaction by the local authorities to suggested IMF policies may reverse the initial, positive impact of IMF policy actions on asset returns in the financial sector. Favorable public reactions also are found to have an important impact on both sector returns. Our results show in the case of the government’s unwillingness to meet its commitment to the IMF programs, investors would disregard the possible positive effects of IMF programs. An important implication of our findings is that the net wealth effect of IMF-related news on investors in private financial markets may be best gauged by considering the actions of not only the IMF, but also the attitude of both the government the public regarding IMF actions.
Key words: Asian crisis, event study, financial and real sector returns, IMF policy, news.
JEL classification codes: F32; F33; F34; G151. Introduction In the past decade several countries have experienced financial crises. Many of these countries have turned to the IMF for financial and technical assistance. In turn, the IMF has advised the crisis-countries and imposed some tough conditions to relief the negative effects of the crisis and move the economy on a growth path.1 However, the impact of Fund programs on economic activity and financial market recovery in a crisis is highly debated. There have been opposing views of the success of the IMF as helping the affected countries recover from the crisis and establish long-run economic growth. First, some observers argue that such programs restore investor confidence and are therefore necessary for financial stability. For example, regarding the nature of IMF programs during the Asian crisis, Michael Camdessus, then the Managing Director of the IMF, stated: “Instead of austerity measures to restore macroeconomic balance, the centerpiece of each program is a set of forceful, far-reaching structural reforms aimed at restoring market confidence. The reforms included in these programs will require vast changes in domestic business practices, corporate culture, and government behavior” (IMF Survey, Volume 27(4), February 23, 1998, p.49). On the other hand, other observers dispute this view and argue that such structural and microeconomic conditions imposed by the IMF may undermine political support for necessary reforms and hence destabilize investor confidence (Eichengreen, 1999). Regarding the IMF assistance to Mexico in 1995, Friedman (1998) also argued that IMF assistance may create creditor moral hazard in that it encourages investors to take an excessive risk because they would believe that an expected IMF support to a crisis-country may provide an implicit guarantees to its creditors (i.e. IMF bailouts) when they lend and invest in countries in trouble. In addition, some observers have argued that the IMF may act as a lender of last resort in a crisis by making sufficient funds to crisis countries and hence can play the role of an international financial institution and secure a world financial order, while others have suggested that such lender of last resort operations may not be desirable because of potential moral hazard effects of IMF lending and may not also be effective due to IMF’s limited financial resources.2
Overall, the impact of IMF programs on crisis countries seems ambiguous. In this paper, we focus on the impact of IMF actions on private financial markets and provide comprehensive evidence on the effectiveness of IMF assistance on asset market performance in Indonesia during the Asian financial crisis. We provide evidence from both financial and real sectors and cover news related to not only IMF actions but also the reaction of the government to IMF policies, the public sentiment about the implemented IMF and government policies, and other underlying situation in the crisis. Because asset returns are forward looking, they provide information about the expectations of investors’ about the effectiveness of IMF programs. Besides its importance for investors, our results have implications for the role of the IMF as the last lender of resort and hence contribute to the recent debate on the effectiveness of international institutions in securing a world financial order.
Although a growing number of studies have examined the impact of IMF actions on asset market returns (summarized in the next section), the majority of these studies focus mainly on financial sector returns because this sector is believed to be at the center of the reasons for the financial crisis (Harvey and Roper, 1999; Krugman, 1998; Stiglitz, 1999). We also focus on real sector because IMF actions not only affected financial sector returns, as significant changes in real sector returns also took place. As far as real sector, we focus on basic materials, consumer goods, and industrials as they make a significant portion of GDP. We believe that the net welfare cost or gain of IMF actions to shareholders can be best understood by examining the developments in both financial and real sectors in response to such IMF news. In this paper we therefore shed some light on the following related questions: How did IMF actions affect financial and real sector returns? During the Asian crisis, the IMF subscribed to restrictive macroeconomic policies in terms of fiscal discipline and higher interest rates while providing liquidity to the financial sectors. Did then the IMF turn a financial crisis into a real crisis by advising restrictive monetary and fiscal policies, which likely favored the financial sectors at the expense of real sectors? Among different real sector categories, did some particular sector returns like consumer goods perform better at the expense of others such as industrials?3 To answer these questions we investigate market reactions to IMF program announcements comparing stock market returns in financial and real sectors. This is the first comprehensive study focusing on real versus financial sector reactions to IMF policy actions and their domestic implications.4 Not only do we account for the impact of news regarding IMF policy actions but also the government’s reaction to and willingness to implement such policies and the public sentiment about the implemented IMF and government policies. Previous studies have mainly focused only on the IMF actions on financial markets, overlooking how the reaction by the local authorities and the public might affect investor behavior.
We focus on Indonesia for several reasons. First, the Indonesian economy suffered the most from the crisis in the region (Cerra and Saxena, 2000). According to Berg (1999), in 1998 real GDP of Indonesian economy declined by 13.7 percent, but the decline was much smaller in Korea (5.8 percent) and in Thailand (about 9 percent). Second, the Indonesian government signed several agreements with the IMF at the beginning of the crisis, and IMF advice continued after the first agreement signed on October 31, 1997 (Hill, 2000). Third, during the crisis period, there had also been several policy actions by the government, either independent of IMF programs or in conflict with the IMF’s position, such as the introduction of a currency board. Such government actions might have contributed to the crisis to the extent that investors perceived the actions not credible because of the potential special relationship between the government and corporate sector. Berg (1999), for example, argued that the close relationship between government officials and the banking system as well as certain private sector participants, especially in Indonesia and Korea, brought about weaknesses in corporate governance and, among others, might have augmented the crisis in important ways. Fourth, a significant level of political violence was observed in Indonesia during the crisis. The violence included ethnic and religious violence in general, and the regional violence in East Timor, Aceh, and Irian Jaya, in particular. Besides such violence, political demonstrations, riots, and chaos took place almost on a daily basis and climaxed in the wake of the resignation of President Suharto. As a result, focusing the analysis on Indonesia is interesting because it allows us to learn about investor behavior and their reaction to IMF assistance in an environment with significant government reaction to IMF actions and political uncertainty. If IMF assistance is successful especially in such stressful environments (i.e., government instability and political unrest), beyond financial stress, by restoring investor confidence, then the role of IMF in providing an international order may be more important than previously thought.
In the next section, we provide a brief review of the literature and further explain our contribution. Section 3 discusses the chronology of key IMF-related events, as well as the other news surrounding the crisis. We discuss our methodology in Section 4, while Section 5 provides a discussion of how we interpret the impact of IMF-related news on asset returns. In section 6, we describe our data and provide some descriptive statistics, while empirical results are reported and discussed in Section 7. Section 8 concludes the paper.
2. Previous Studies and Our Contribution
There is scant literature on the effects of IMF events on stock prices.5 Available literature on stock markets focuses on the response of international bank creditors rather than on local financial companies. Kho and Stulz (2000) examine the impact of IMF assistance on the value of bank stocks, both local and international, during the Asian financial crisis. They conclude that the IMF programs had a positive but small effect on international bank values, while the effect on crisis countries’ banks was insignificant. In a related study, Dong, Kho and Stulz (2000) investigate the impact of the announcement dates of IMF support programs on the abnormal returns of the U.S. banks during crises in Mexico, Brazil, Korea and Russia, and they report results similar to those as in Kho and Stulz (2000) in that these banks tend to earn high abnormal returns. Zhang (2001) investigate the impact of the IMF announcements during the Asian crisis on international bank equities in Korea and find evidence consistent with Kho and Stulz (2000) and Dong et al. (2000). Overall, these studies found that IMF news has a significant positive influence on international bank returns, but the impact on banks of the crisis countries is either not studied or only briefly mentioned as insignificant.
Brealey and Kaplanis (2004) look at a broad sample of IMF programs, other than those implemented during the Asian crisis. They also study a wider range of financial assets than those included in Kho and Stulz (1999) and Dong et al. (2000). They find a substantial decline in a variety of asset prices in the weeks leading up to the announcement of the IMF programs, but there is no evidence that the announcement of the IMF support caused any part of these wealth losses to be reversed.
Hayo and Kutan (2005) investigate the reaction of composite stock market returns and volatility in a diverse group of six emerging markets to a different set of IMF events, such as delay of loans, program approvals, etc. They find that, on average, negative (positive) IMF news reduces (increases) daily stock returns by about one percentage point. The most influential single event is the delay of loans from the IMF, which reduces stock returns by about one and a half percentage points. IMF news does not appear to have a significant impact on the volatility of stock markets, which may act as a proxy for risk. Evrensel and Kutan (2007) examine the impact of IMF news on daily financial sector stock returns in Indonesia, Korea, and Thailand. They consider two sets of news items, namely IMF program negotiations and their approval and find significant impact of IMF news on both financial and real sectors.
In this paper, besides banking sector, we provide specific evidence on financial sector that includes insurance, investment companies, real estate, and other related financial sectors in Indonesia. In addition, we also include three major real sectors, namely, the basic material, consumer goods and industrial sectors. Basic materials, which include basic resources, chemicals, forestry and paper, metal and mining; the industrial sector, which include aerospace and defence, diversified industrials, electronic and electrical goods, and accounted for the largest share of GDP during the crisis period; and the consumer goods sector that include automobiles and parts, food and beverages, health, household goods and textiles, personal care, pharmaceuticals and tobacco, accounted for some 25% of GDP in 1998. The biggest companies in these sectors were also owned by the same conglomerates that owned banks that failed during the crisis. It is, therefore, interesting to note how the performance of these sectors might be similar or different from the banking and the financial sectors. During the Asian crisis, the IMF advised tight monetary policy by supporting high interest rates in order to restore confidence in the currency. There is therefore a good reason to think that the effects of IMF news might affect these sectors differently, especially if there are other factors driving them, such as international commodity prices (for basic materials), imported input prices and interest rates (for industrials), and interest and inflation rates (for consumer goods).
Our empirical investigation differs in other ways from many of the previous studies. First, previous studies mainly consider the impact of IMF programs on asset returns. They do not account for the reaction by the government and the public to IMF policy and actions. In this paper, besides IMF policy news, we also account for news about the underlying situation in the country, local authorities’ policy reactions to IMF programs, reactions of public to the implementation of IMF polices in terms of political unrest and riots, and any other ongoing news that could affect the financial markets. Second, previous studies focus on international bank stock returns, financial sector returns or composite (aggregate index) returns but we also include real sector returns. Because IMF actions would also affect returns in real sectors, such as industrial and consumer goods, the overall wealth implications of IMF actions for investors may be best captured by studying both financial and real sectors. If IMF-related news increases financial sectors returns, but decreases returns in real sectors, an investor holding both assets may end up with a net welfare loss. Third, our study aims at drawing more generalized conclusions on the impact of IMF-news on the real sectors by expanding the earlier studies that investigate the impact of IMF bailouts on real sectors during other crises, such as those in Mexico, Brazil, Korea and Russia (i.e., Dong et al., 2000). Following Kho and Stulz (2000) and Dong et al. (2000), we use an event-study methodology to capture the wealth effects of IMF actions in both financial and real sectors.
In the next section, we describe the chronology of events and classify the events from different angles to better capture the overall effect of the IMF actions on investor wealth.
3. Event Classification and Chronology of Events
The decision to select IMF-related events is a difficult one. Usually there is a sequence of events that leads to the official announcement of a rescue package by the IMF. The major problem with just focusing on IMF actions is that during the same period these are not the only events that that could affect stock returns.6 This is a major problem especially in our case because during the crisis period Indonesia had experienced several other events such as political unrest, government instability, and significant reaction to IMF assistance by the government and news by both the public and local people. We therefore categorize the events in a comprehensive way. In particular, we have the following event categories:7
News about the underlying situation. They capture the environment prior to the crisis in the country and the government’s request to ask for help from the IMF.
News about the IMF’s policy reaction. They summarize how the IMF reacts to the crisis and the request from assistance from Indonesia, as well program approvals and conditions imposed on the government to keep receiving IMF assistance.
News about the local authorities’ policy reaction. They show how the local authorities, including government and key governmental organizations, react to IMF’s assistance and conditions.
Reaction by the public and companies to local authorities’ polices following IMF help/agreements, including political unrest, riots, etc.
Other ongoing news during the crisis period that might affect the financial markets.
We present the details of IMF related events in Table 1. Column 1 presents the date of the event, while column 2 presents the event descriptions. In column 3, we give event classifications as above. In addition, in column 4, we further classify the news into good news bad news to see how such news in general had affected the market sentiment and hence returns, in both financial and real sectors. Arguably, the designation of good and bad news is subjective. In this study, we classify a news as good if it was expected to affect market sentiment positively. This includes news of IMF program approvals and news about government actions that are in line with IMF provisions. We classify bad news as those that would adversely affect market confidence, which include announcements of government policy that run against its commitments to IMF programs and political instability arising from unfavorable IMF policy actions. Announcements of IMF policies may not be as clear cut, however. This is because the market might view the adoption of IMF programs not only as a positive signal, but also as a sign of economic frailty or the government’s incapacity to tackle the crisis. However, such double interpretations became more common after the Asian crisis, and for this study we assume that news were either good or bad (for the market).
As we discuss the news in a chronological order, we also present the raw stock returns in Indonesia during the critical event days to see how markets reacted to crisis-related events. These raw returns are reported in Table 2.
In the past, the government of Indonesia has managed to use its access to multilateral financial organizations, such as the IMF, in a credible way. Thus, there was no hesitation to use this access, publicly, once more. Such a step was deemed to be able to stem the panic. This was different from the Korean case, whose government contacted the IMF in secret, with the assumption that such news would give the impression that the government was not in control of the situation. The 1997-1998 crisis in Indonesia was influenced by political development in the country as well. Agreement with the IMF was struck four times within several months. What characterized these agreements was the almost immediate reversal of position by the Indonesian government right after the signing of the agreements. In a chronological order we summarize these programs below and also discuss the underlying news related to each program.
The November 1997 IMF program
In September 1997, with the continuing decline of the rupiah, the government of Indonesia notified the IMF that it might need a ‘precautionary’ arrangement. On October 8, 1997 when the government requested help from the IMF stock returns increased by 4.79% in Financials and 3.95% in Banks, while real sectors had much milder reactions (Table 2). Subsequently IMF missions visited the country in October. The first agreement was announced on October 31, 1997 and signed in November. According to this agreement, key policies to be implemented included the following: “First, the authorities will maintain tight fiscal and monetary policies, designed to stabilize financial conditions and narrow the current account deficit. Substantial fiscal measures have been put in place to keep the budget in surplus, despite the cyclical downturn, while monetary policy will be kept tight. Second, prompt and decisive action will be taken to restore the health of the financial sector, including closing unviable banks. Third, a broad range of structural reforms will be implemented, including liberalization of foreign trade and investment, dismantling of domestic monopolies, allowing greater private sector participation in the provision of infrastructure, and expanding the privatization program” (IMF Press Release, November 5, 1997).8 The program had the objective of restoring market confidence by maintaining prudent macroeconomic policies, addressing weaknesses in the financial sector, including the closure of 16 banks; and undertaking structural reforms to improve economic efficiency. On the first trading day after the announcement of the program on October 31, 1997 stock returns declined by -2.05 % in Financials and -3.51 % in Banking sectors while the reaction in real sectors was much milder in real sectors in general and positive with a 4.42 % in Basic Materials in particular.
There were no significant political events taking place on the date of the announcement, nor immediately after, and the market responded positively in the first couple of days after the announcement. The day after the announcement of the IMF agreement, the government closed 16 banks and the rupiah improved in the next couple of days. However, on November 5, 1997, a bank partly owned by a son of the President filed a lawsuit against the Finance Minister and the central bank Governor. Stock returns fell in all sectors. On November 7, 1997, the government reversed its decision to halt 15 large infrastructure projects. Stock returns continued falling, with the highest fall of -3.43% in Banks. Despite a visit by the IMF Managing Director on November 11, to which the investors reacted positively by 4.39% in Industrials and 2.10% in Banking, the President’s son bought a small bank on November 23 and began operations on the premises of his old bank. Stock returns declined by -6.68% in Banking sector, and -4.62% in Financials with milder falls in real sectors.
At the end of December, on December 30,1997, the Jakarta court decided to delay the liquidation of another bank owned by the President’s half brother (IMF /IEO, 2003). Real sectors reacted positively with Basic Materials increasing by 5.81% and Consumer Goods increasing by 3.50%. The government’s position was neither unified nor firm. The economic ministers, who were in favor of the IMF program, were undermined by the President and his relatives, whose interests were in danger of being swept aside by the IMF program.
The January 1998 IMF program
In November and December 1997, the political dimension of the crisis began to appear. Ethnic and food riots began to take place more often. The President fell sick in early December and raised questions about succession. The IMF drew up another agreement with detailed structural reform agenda, accommodating the opinion of IMF’s major shareholder’s government that extensive structural reform was needed. The IMF Managing Director attended the January 15 signing of the program. On the day, stock returns rallied by 25.45% in Banking sector, 19.05 % in Financials while Basic Materials responded most among the real sectors up with 10.36%, and returns in Consumer Goods and Industrials were up by 2.65 % and 1.57%, respectively. The program included provisions to cancel 12 infrastructure projects, cancelation of privileges for the National Car Project owned by the President’s son, elimination of state agricultural products distribution monopoly, elimination of the clove marketing monopoly, also owned by the President’s son. However, the program was never presented to the IMF Executive Board because revised budget targets became immediately irrelevant due to the rapid depreciation of the rupiah (IMF/ IEO, 2003).
The next day, on January 16, the rupiah was reported to take another plunge, while food riots were reported. On January 27, the government announced a blanket guarantee on commercial banks. Stock returns were up by 7.44% in Banks and 9.81% in Financials. Consumer Goods were up by 8.04% while Basic Materials and Industrials were up by 1.47% and 2.92%, respectively. On February 12, the President replaced the finance minister and the government indicated that it would opt for a currency board arrangement. Financial sector reacted negatively with a fall of -7.19% and real sector reacted positively with a rise of 7.68% in Basic Materials, 1.67% in Industrials, and 1.54% in Consumer Goods.
News of food riots continued to be reported during the months of February and March, while the government and the IMF disagreed on the currency board issue. On March 10, 1998, the President was re-elected. Real sector reacted positively with a 5.16% increase in Industrials and 2.46% increase in Basic Materials sectors and financials and banks increased by 1.86% and 1.08%, respectively. On March 21, under pressure from the IMF and other countries, the currency board option was dropped. Returns are dropped by -1.52% and-0.72% in financials and banks, respectively and by -4.29% in consumer goods and -2.55% in Basic Materials. After the re-election the President seemed to be supportive of IMF program and the government worked toward another agreement with the IMF.
The April 1998 program
On April 8, a new agreement was announced. In the April agreement, the fiscal position was relaxed, allowing a deficit of 4.7% of GDP. Interest rate was also raised sharply. The program also included the elimination of subsidies on agricultural products, privatization of state-owned enterprises, and the lifting of restrictions on foreign investment. Real sectors reacted most with a fall of 4.16% in industrials accompanied by increases of 1.84% in Basic Materials. The President then took a step to increase fuel prices on May 5. Initial reactions were mixed with returns increasing by 13.34% in industrials and financials and falling by -2.65% in Banks. This triggered demonstrations and protests on the same day and up until May 9. On May 12, demonstrators at a university in Jakarta were fired upon, resulting in civilian casualties. Protests on May 13 and 14 soon turned into riots, which lasted for almost two weeks, culminating in the resignation of the President on May 21. Market reaction was positive in all sectors. Returns were up by 2.99% in banks and 6.60% in financials. In all real sectors prices were up; by 6.02% in Basic Materials, 3.14% in Industrials, and 4.53% in Consumer Goods. This marked a breaking point during the crisis. The new President, Habibie, prioritized on economic stabilization and rescheduled public debt. The IMF and the government negotiated a new program, which was announced on June 24, 1998. The agreement included measures to deal with bank restructuring. Reactions were positive in financials and banks, up by 3.48% and 1.65%, respectively. Reactions were slightly negative in real sectors such as Basic materials that experienced a fall of -2.76% and industrials that fell by -0.76% while there was a -0.44% increase in Consumer Goods.
The raw returns presented here do not have any statistical support and hence may not capture the true wealth effect reflected in cumulative abnormal returns. To deal with this issue, we use an event-study methodology. In the next section we explain the methodology and Section 5 describes the data set and reports our empirical results.