00074910012331337783
Bulletin of Indonesian Economic Studies
ISSN: 0007-4918 (Print) 1472-7234 (Online) Journal homepage: http://www.tandfonline.com/loi/cbie20
Bank Indonesia and The Recent Crisis
J. Soedradjad Djiwandono
To cite this article: J. Soedradjad Djiwandono (2000) Bank Indonesia and The Recent Crisis,
Bulletin of Indonesian Economic Studies, 36:1, 47-72, DOI: 10.1080/00074910012331337783
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Bulletin of Indonesian Economic Studies
Vol 36 No 1, April 2000, pp. 47–72
BANK INDONESIA AND THE RECENT CRISIS
J. Soedradjad Djiwandono*
University of Indonesia and
Harvard Institute for International Development
This paper is a personal note describing the crisis as it unfolded while the
writer was a key player in Indonesia’s macroeconomic management. The
crisis is seen as multi-faceted. It originated externally from a shock in the
currency market that triggered a downward spiral from currency
depreciation to fully-fledged crisis. The currency shock that hit the rupiah
in July 1997 exposed in sequence the flaws embedded in the banking sector,
the economic system, the social and the political system, flaws that had
been obscured by long years of good economic performance. Through a
complicated process of contagion and feedback effects—market
disturbances, policy responses and market reactions—Indonesia
deteriorated from a relatively well managed economy to the ‘worst case’
among the Asian crisis economies. The paper discusses this process, the
IMF’s role, the bank closure issue, the currency board controversy and
the author’s dismissal as Governor of Bank Indonesia.
INTRODUCTION
The Indonesian crisis is now more than two years old, yet there has not
been a clear signal that the economy is truly heading toward recovery,
let alone sustainable, balanced and broad-based development. Following
the much better than expected general election of 7 June 1999, there were
encouraging developments in the economy and in the social and political
spheres as macro indicators improved. However, this did not last long
enough to support a more sustained path toward recovery and growth.
Expectations arising from both external developments and domestic
events produced a recurrence of economic strains, resulting in further
pressures on the rupiah and on equity prices.
Of the three worst hit crisis countries in Asia, Indonesia’s recovery is
by far the slowest. Thailand and especially Korea seem to have remained
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48
J. Soedradjad Djiwandono
on a steady path of recovery. The latest developments confirm that
Indonesia is the ‘worst case’ among the Asian crisis economies. More
careful analysis is needed to explain the peculiar character of the
Indonesian crisis.
This paper is a personal assessment of the Indonesian crisis from the
vantage point of my position as Governor of Bank Indonesia during a
critical part of the crisis period. I would like to offer my recollections of
how the crisis developed from an external shock in the currency market,
rapidly spreading wider and deeper in a complicated process of contagion
to become a fully-fledged crisis, through the impact of shocks, policy
responses and market reactions. The period of the crisis from its beginning
in mid July 1997 to the time of my untimely departure from office in mid
February 1998 may be the most confusing part of Indonesia’s history of
economic policy management, and deserves to be documented for future
scrutiny.
THE CRISIS AND ITS IMPLICATIONS
There have been many conferences and writings on the Asian crisis,
discussing its nature and causes, its implications, and the lessons to be
learned from it. One can be sure that such studies will continue in the
years to come. This is because, despite the attention it has received, the
crisis has persisted for longer than expected, and its effects have been
more devastating than most people would be prepared to accept. The
Asian crisis has been followed by the Russian and Brazilian crises.
Recent developments seem to suggest that the crisis is over, or close
to over, and most people agree that it is generally behind us. For example,
at the Interim Committee Meeting of the International Monetary Fund
(IMF) in the northern spring of 1999 it was reported that, of the three
hardest hit countries in Asia, Korea was experiencing a recovery, the Thai
crisis was bottoming out, and Indonesia was following suit. Brazil was
considered to be out of the crisis, while Russia was close to having a new
IMF-supported program. The ‘Survey of Recent Developments’ in the
August 1999 issue of BIES (Pardede 1999) presented a similar view of
Indonesia’s progress.
But more recent developments in Indonesia, and to a certain degree
also in Thailand, have raised new concerns (Krugman 1999; Arnold 1999).
The still fragile recovery in some crisis countries has been challenged by
new problems arising from the expectation and ultimate implementation
of an interest rate hike in the US, and from the new fear of a yuan
devaluation. In Indonesia, the good news about a much better than
expected general election was tainted by the Bank Bali scandal and the
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Bank Indonesia and the Recent Crisis
49
atrocities in East Timor, which immediately put pressure on the rupiah
and on equity prices.1
Views on the causes of the crisis are many. However, over time some
consensus seems to be developing. Differences might be narrowed down
to two perspectives, which could be distinguished much as we
differentiate between the Classical and the Keynesian economists’ views
on the workings of the market. With respect to the Asian crisis, we could
distinguish between those who see its origin as domestic and those who
view it as originating externally. The first group argues that the crisis
arose from practices of crony capitalism and weak financial structures,
together with inept macro policies; the second group sees it as triggered
by a shift of sentiment in the financial market that caused a contagious
process of financial panic. The first view, put by people such as Professor
Krugman of MIT, could be considered as a structural explanation of the
crisis (Krugman 1998). The second view argues that the crisis was
essentially a case of financial panic in the Keynesian tradition, as
succinctly explained by Professor Kindleberger in his seminal work two
decades ago (Kindleberger 1996). Professor Jeffrey Sachs has been the
major proponent of this view (Radelet and Sachs 1998).
As one who had first-hand experience of the crucial part of the
Indonesian crisis, I would argue that it was not determined by one single
variable, whether external or domestic in origin. It is my view that the
Asian crisis, and in particular the Indonesian crisis, arose from a
combination of the workings of ‘contagion’ forces from outside the
national economy on the one hand and weak domestic economic and
financial structures on the other. The contagion factor emanated from a
sudden change in market sentiment in the region that led to a shock in
its currency markets. This resulted in panic selling of local currencies,
and of other assets denominated in local currencies, for dollars.
The rapid downgrading of the region’s sovereign credit ratings by
international rating agencies further fuelled the shift in market sentiment,
triggering panic selling of foreign-owned local assets. In the media, the
term ‘Asian miracle’ disappeared suddenly, to be replaced by ‘Asian crisis’
or ‘Asian meltdown’. But the most telling sign was the Institute of
International Finance’s publication on capital flows for Thailand,
Malaysia, Indonesia, the Philippines and South Korea. The estimates
showed a reversal in flows of capital of $105 billion in these five countries
in a single year, from inflows of $93 billion in 1996 to outflows of $12
billion in 1997. For Indonesia alone, the reversed capital flow was
estimated at $22 billion, from inflows of $10 billion to outflows of $12
billion. This was indeed a financial panic in the Keynesian tradition, as
explained by Kindleberger (1996).
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50
J. Soedradjad Djiwandono
But the external shock itself need not have caused a crisis of the
magnitude that these countries suffered, if only their domestic economic,
social and political structures had been robust. Confronted with a
contagious external shock the Indonesian economy, with its embedded
inefficiencies and weak financial system, could not withstand its impact.2
The domino effect of the weakening rupiah adversely affected the
financial sector, and then the real sector of the national economy. Thus, a
combination of severe external shock triggered by changes in market
sentiment, and financial-cum-real sector structural weaknesses, caused
a contagious process that severely damaged the entire economy.
The Indonesian crisis developed as a sequence of events which began
with an external shock—part of a contagious financial panic in the
region—that hit Jakarta’s financial market. The shock, the policy response
and the market reaction exposed the fragility of the national banking
system, leading to a banking crisis. In turn, the banking crisis seeped
through the payment system, revealing weaknesses in the real sector of
the national economy—which was basically a system of ‘ersatz capitalism’
in Yoshihara’s characterisation (Yoshihara 1988), with embedded
inefficiencies and widespread corruption—and led to an economic crisis.3
The economic crisis exposed institutional weaknesses in Indonesia’s social
and political system. In a complex and intertwined set of relationships,
with feedback effects, the financial crisis turned rapidly into a multifaceted crisis, crippling not just the national economy, but society and
politics as well.
Many argue that the Asian crisis stands out as one of the major crises
since the depression of the 1930s. Its impact has been so devastating that
even pessimists acknowledge it has been worse than they expected.
Indonesia, Thailand and South Korea have suffered more severely than
other countries. And it is becoming apparent that, of the three, Indonesia
has suffered the most in terms of the decline in economic growth, the
depreciation of the currency, social dislocation and other problems.
The virulent nature of the Indonesian crisis has been well documented.
Its chief features may be summarised as follows.
• The economic deterioration has been devastating. A single year
(1998) saw the drastic reversal of a long period of high GDP growth
rates, from 7–8% annually to negative growth of close to 14%; a
50% cut in income per capita in dollar terms; a sizeable reversal
in private capital flows (the estimates range between $25 and $40
billion); a jump in the inflation rate from single digits to 80%; and
an 80% depreciation in the rupiah in less than 12 months.
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Bank Indonesia and the Recent Crisis
51
• The social and political impacts have also been severe. They
include a dramatic rise in unemployment, especially in urban areas
of Java—some estimates put the figure at more than 5 million
additional people unemployed; a drastic increase in the number
of people living below the poverty line, from 11% to close to 25%
of the total population in 1998; a large rise in school dropouts at
all levels of schooling; an increase in the rate of petty crime and
prostitution; and other social problems.4
• Aside from the horrors reported in Ambon, West Kalimantan, East
Timor and elsewhere, there have been other indications of social
disintegration. In addition to the infamous riots that caused the
death of more than 1,100 people and the burning of houses, looting
and rapes in May 1997, Crosby Corporate Advisory reported that
in 1998 there were nearly 2,000 student demonstrations; 1,300
rallies by non-government groups; 500 strikes; and 50 riots.5
• The crisis forced Soeharto, who had ruled the country for 32 years,
to resign in disgrace. He was succeeded by his close protégé, Dr
Habibie, who served as President from 21 May 1998 until October
1999, when the MPR elected Abdurrahman Wahid as the new
President.
It is my conviction that the Indonesian crisis originated from an
ordinary currency problem, when the rupiah suffered from sudden
pressure in July 1997 after the floating of the Thai baht earlier that month.
However, after a sequence of policy responses by the government and
market reaction thereafter, the problems spread rapidly and deeply to
affect all sectors of the national economy, before finally impacting on
politics.6
POLICY RESPONSES AND MARKET REACTIONS
Faced with the currency shock in early July 1997, the government took a
decision to widen Bank Indonesia’s intervention bands on 11 July. It was
almost a routine exercise, since Bank Indonesia had done this a number
of times before. This decision was lauded by many, including
representatives of donor countries at the CGI (Consultative Group on
Indonesia) meeting in Tokyo several days later. Some papers reported
Bank Indonesia’s step as a ‘preemptive’ measure.
Market reaction was not as expected, however; in fact it was the
reverse of previous experience. In the past, whenever Bank Indonesia
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J. Soedradjad Djiwandono
had widened the bands, the rupiah had appreciated, and the dollar spot
exchange rate had closely followed Bank Indonesia’s buying rate. But
this time the rupiah depreciated after the bands were widened. The dollar
spot rate not only broke through the mid rate, it also broke through the
selling rate or upper band. What happened in July 1997 was different
from previous periods of pressure in the currency market. A contagion
effect was in progress.7 Since investors were convinced, partly by rating
agencies and financial analysts, of the presence of similar structural
weaknesses within the economies in the region, their ‘herd instinct’
dictated that they should move their investments out of Asia.
When the spot rate broke BI’s selling rate the central bank intervened
in the market, first by selling dollars forward, and later in the spot market.
Market intervention from the third week of July until the day before the
rupiah was floated in the spot market amounted to $1.5 billion.8 When
these efforts did not stabilise the rupiah, and given that it was now the
only currency in the region that was not freely floating, the government
decided to free float the rupiah on 14 August 1997.
This was supported by monetary tightening through the raising of
interest rates and sterilisation and by fiscal tightening. Bank Indonesia
had already reduced bank liquidity in late July by ceasing to allow banks
to rediscount their own papers (SBPUs). But a more stringent step was
taken in mid August, when the central bank raised the rates for some BI
certificates (SBIs) to at least double their previous level. For example, the
one-week SBI rate was raised from 10.5% to 20%, and the three-month
rate from 11.5% to 28%. On 29 August Bank Indonesia also issued a new
rule limiting the forward sale of dollars to non-residents to $5 million, to
reduce currency speculation.
On the fiscal side, the Minister of Finance cut government spending
by rescheduling some projects and limiting routine expenditures on nonpriority items. He also instructed a number of state enterprises and
foundations to transfer their bank deposits of Rp 3.5 trillion to SBI
holdings.9
But following the shock, the policy response and the market reaction,
a new phenomenon developed. In reaction to the monetary and fiscal
tightening, the weak banking sector began to suffer distress. Bank runs
emerged as early as the second half of August 1997, when the process of
‘flight to safety’ began. And the interbank money market became
compartmentalised, with ‘suspect’ banks having to pay much higher
interest rates to borrow from other banks. Interbank rates increased
dramatically, from an average of 22% to more than 80%. There was even
an occasion when the overnight interbank rate reached 200% per annum.
By the end of August 1997, more than 50 banks had failed to comply
with the minimum reserve requirement of 5%.
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Bank Indonesia and the Recent Crisis
53
Realising that the problem had spread to the banking sector, the
government launched a broad economic policy initiative on 3 September
1997. The policy package encompassed not just monetary and fiscal
measures, but also steps in the real sector, in the form of further trade
liberalisation steps and the rescheduling of government projects with
high import content. The government promised to continue adhering to
an open foreign exchange policy. With respect to the banking sector, it
announced steps that included a promise to keep helping solvent banks
facing liquidity problems, a more active effort to encourage bank mergers,
and a policy of closing insolvent banks, with a pledge to take care of
small deposit holders’ interests with state banks.10
Despite all these efforts, not much progress was made in stabilising
the currency or containing the banking problem. In the process, more
banks became unable to comply with the minimum reserve requirement,
and some even began to have a negative balance with Bank Indonesia.
The economic team in the government was convinced that Indonesia
was facing a confidence problem. A concerted effort had to be made to
restore confidence. This led to the idea of seeking International Monetary
Fund assistance to boost market confidence. The preliminary discussions
on inviting an IMF team were held when Dr Stanley Fischer, First Deputy
Managing Director of the Fund, visited Jakarta at the invitation of the
Minister of Finance, on his way to the 1997 Annual Meetings of the World
Bank and the IMF in Hong Kong. This happened some time in mid
September 1997.
During the meeting with Dr Fischer, I proposed a precautionary
arrangement with the Fund, instead of a fully-fledged standby
arrangement. This idea was pursued further in Washington, but it was
pushed aside during the follow-up discussions between the IMF team
headed by the Fund’s Director for the Asia–Pacific, Hubert Neiss, and
Minister Mar’ie Muhammad and myself, during the annual meetings in
Hong Kong. Because of the rapid deterioration in Indonesia’s financial
position, the discussion shifted rapidly to a standby arrangement.
My original preference for a precautionary rather than a standby
arrangement was based on a conviction that our economic circumstances
were not so bad, at least in terms of the foreign exchange reserves that BI
held at that time. I would still argue that this is true. Thailand and Korea
were in a much worse position in terms of their reserve holdings at the
time the Fund was invited in. Our problem then was to restore market
confidence, and this objective could be well served by the presence of
the IMF under a precautionary arrangement. But a more important reason
was that I was afraid I would not be able to persuade the President to
agree to the stringent conditionality of a standby arrangement. A
precautionary arrangement would bear much less stringent conditions,
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J. Soedradjad Djiwandono
even though it did not automatically include funds. Funding was not
our major problem—at least that was how I looked at the circumstances
then. 11 The most crucial issue was the lack of market confidence in
macroeconomic management, which would have been restored through
IMF support of government policy. In the past, other countries like India
and South Korea had been successful in addressing their problems
through IMF precautionary arrangements.
The IMF-supported program for Indonesia summarised in the
Memorandum on Economic and Financial Policies (MEFP) was submitted
to the Fund via a letter of intent (LOI) on 31 October 1997. The program
comprised a package of policies for economic reform in both the real and
the financial sector, supported by prudent monetary and fiscal policy.
The monetary and fiscal measures consisted of standard programs of
macroeconomic management to stabilise the exchange rate and other
monetary variables.
The core of the program was a policy package to deal with insolvent
and weak banks and strengthen financial infrastructures, and to overcome
structural rigidities in the real sector of the national economy. Thus, the
framework was put in place for a comprehensive policy to restore
confidence and arrest the decline of the rupiah. In essence, the program
was built around three areas:12
• a strong macroeconomic framework designed to achieve an
orderly adjustment in the external current account, incorporating
substantial government spending cuts and a tight monetary
stance;
• a comprehensive strategy to restructure the financial sector,
including early closing of insolvent institutions; and
• a broad range of structural measures to improve governance in
the government as well as the corporate sector.
Initially, the implementation of the program received a positive
response from the market, the external market in particular. The closing
of 16 insolvent banks, and joint intervention in the currency market by
Bank Indonesia, the Monetary Authority of Singapore and the Bank of
Japan, were welcomed by the external market, and resulted in a
strengthening of the rupiah, which for a while rose from Rp 3,700
to Rp 3,200/$.
However, the domestic reaction to the closing of banks was the reverse
of what was expected. It was ironic that a step designed to restore
confidence in the banking sector instead resulted in a collapse of
confidence, plunging the sector into chaos. It continued to suffer from a
process of ‘flight to safety’, with bank runs becoming common. Many
banks lost their deposit base, and the interbank money market became
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Bank Indonesia and the Recent Crisis
55
seriously compartmentalised. In addition, from January 1998 many banks
found that trade and other financial lines from their bank business abroad
were terminated. Letters of credit issued by many Indonesian banks were
not accepted overseas. This plunged the banking sector from a state of
distress into a state of crisis, with market confidence almost completely
lost.13
After some ‘flip-flop’ implementation of the IMF-supported program,
the confidence problem shifted from being just an economic problem to
being one of national leadership. The negative reaction to the IMFsupported reform program became more pronounced when the loss of
confidence caused by the bank closures was further complicated by a
government announcement to reverse a decision to postpone several large
government projects. At about the same time, monopoly practices and
other inconsistencies reappeared in the implementation of the program
for restructuring the real sector. In this way market confidence in the
government’s commitment to the economic restructuring program
evaporated. As a result, not only was the rupiah’s slide difficult to stop,
but the economic crisis was spiralling into a ‘total crisis’.
SOME NOTES ON THE IMF-SUPPORTED PROGRAM
With the crisis now more than two years old, policy responses to the
problems and market reactions, including feedback responses, can be
better understood with the benefit of hindsight. Some comparisons can
also be drawn with the experience of other countries in Asia. It should be
noted here that, even though we tend to treat problems in the crisis
countries as similar, they are not identical, since each crisis has its own
peculiarities. Indonesia, despite its relatively better conditions and better
early policy response, has ultimately become the worst case among the
countries experiencing crisis, and the slowest in its path towards recovery.
Among Asia’s crisis countries, Thailand, Indonesia and Korea all
sought IMF support, while other countries in Asia did not. Malaysia faced
the crisis on its own, including resorting to capital controls, even though
before being sacked Minister of Finance Anwar Ibrahim was known to
subscribe to stringent policies in the IMF tradition. Meanwhile, the
Philippines had been on precautionary arrangements with the IMF for
some time.
Thailand signed its first letter of intent on 2 July, Indonesia on 31
October, and Korea on 1 December, all in 1997. Each of these countries
was granted standby support under the Emergency Financial Mechanism
(EFM), introduced a year earlier to hasten the decision making processes
of the IMF’s Board and the disbursement of loans. Korea was the first
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J. Soedradjad Djiwandono
country to receive a standby loan based on the newly modified EFM
with its faster disbursement mechanism. All these programs have two
types of funding sources, namely the ‘first line of defence’, comprising
IMF, World Bank and Asian Development Bank (ADB) loans, and the
‘second line of defence’, consisting of bilateral loans from countries
attached to these programs.
Before seeking IMF support, all three countries had been dealing with
strong pressure on their respective currencies by resorting to their own
means of foreign exchange management. They began their defence against
the currency onslaught by way of intervention in the foreign exchange
market, in line with their adherence to a pegged system of foreign
exchange management—a rigid pegged system in the case of Thailand
and Korea, and a managed float in the case of Indonesia. After losing
substantial reserves in market intervention, particularly in the first two
countries, one by one the three abandoned their pegged systems, and
moved to a floating foreign exchange system. But when market confidence
was shaken, each sought IMF support in an effort to restore market
confidence.
In general, an IMF-supported program contains adjustment policies
that a country promises to adopt to deal with imbalances from a shock or
crisis. Since the Asian crisis is multifaceted, reflecting a variety of problems
and weaknesses, a sustainable program to address the problems of the
crisis effectively must also comprise several aspects. There has been much
criticism of the IMF’s handling of the Asian crisis. Its general thrust is
that this crisis is not typical of the problems the IMF was set up to deal
with. On the whole, the Asian crisis countries have not suffered from
budget deficits, hyperinflation or even chronic balance of payments
deficits. Yet the IMF therapy, at least the one usually emphasised, is a
tight money policy with sky-high interest rates. There is some truth in
this criticism, even if it is not entirely valid. Among the many factors
causing or contributing to the crisis in Asia, the important common
elements in the crisis-affected countries are a weak banking or financial
system and unsustainable corporate short-term debt in foreign currencies.
No stabilisation and recovery program will be effective in solving the
crisis unless it seriously addresses these two problems.
There are slight variations in each country, but generally the IMFsupported programs adopted to face the crisis comprised financial reform
and economic restructuring, complemented by prudent monetary and
fiscal policy. The classic IMF approach is, of course, monetary and fiscal
policy to address monetary instabilities, like inflation and balance of
payments problems, and fiscal imbalances. But its capacity to deal with
problems of economic structure, such as monopolies and oligopolies and
the practices of crony capitalism, granted that these are real issues in the
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Bank Indonesia and the Recent Crisis
57
countries concerned, has raised controversy. Measures to address
problems of bank restructuring and corporate debt have also drawn
criticism. It is important to acknowledge that in all these cases the Fund
has worked together with its sister institutions, the World Bank and the
ADB, to mobilise a pool of expertise to deal with these complex problems.
Since the fundamental problem facing these countries is one of market
confidence, the presence of the multilateral agencies is crucial. They must
show their support of these countries’ adjustment programs through their
expertise, but also through the provision of significant funds that can be
speedily drawn. Hence, the Emergency Financial Mechanism and the
huge magnitude of the loans.14
Thailand’s standby loan from the Fund was $4 billion, which
constituted 505% of its quota. Indonesia’s original loan was $10 billion,
or 490% of its quota.15 In July 1998 an additional $1.5 billion loan was
approved, making the total more than 500% of Indonesia’s quota. Korea’s
loan of $21 billion amounted to 1,939% of its quota (Lane et al. 1999). In
addition, each country also acquired loans from the World Bank and the
ADB, which could be drawn relatively quickly. Likewise, each received
some lines of credit from bilateral countries, which were linked to the
IMF standby facility. In general, these loans could only be used when
sources from the multilateral institutions had been exhausted, hence their
status as a second line of defence.
The practice of maximising the apparent magnitude of loans in the
context of an IMF standby arrangement, by including loans from different
countries in the package as part of a second line of defence, has not been
very meaningful in confidence building.16 The market is not easily
impressed with these numbers, and most market players know how
difficult it is for recipient countries to cash in the second line of defence
facilities.17 On the other hand, since the media always used these higher
numbers, in the case of Indonesia the well known phrase ‘the $43 billion
IMF-bail out’ may have given the wrong impression to an uninformed
public, at least about the size of the national debt.
In a way, since the original purpose of acquiring IMF support was to
restore market confidence, the availability of lines of credit from bilateral
donors may have provided creditors and investors of the recipient
countries with some sense of security in their respective claims. These
credit lines would certainly cushion the reserves held by the countries
accepting IMF support. If creditors and investors were convinced, then
this would reduce the demand for foreign exchange. It would also reduce
the pressure for creditor countries to stop providing trade financing and
money lines to the Indonesian banking community. And this could
happen without the recipient countries drawing on the facilities provided
in the scheme. However, if the program were not acceptable to creditors
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J. Soedradjad Djiwandono
and investors, as was the Indonesian case, the pressure to withdraw
existing loans would remain, and the demand for foreign exchange in
the market would keep rising. Indonesia’s experience with the gimmick
of describing the program as a huge ‘IMF bail-out’ was that it did not
seem to contribute to the objective of restoring market confidence in the
banking sector and in macroeconomic management.18
I should also mention that there was never a clear statement of the
amount of ‘first line of defence’ assistance available to Indonesia when
the IMF agreed to provide a loan in support of a standby arrangement
based on the 31 October 1997 LOI. It was announced that the amount of
the IMF loan was $10.5 billion. If this amount is added to the World Bank
and ADB loans of $7.5 billion, the amount readily available becomes $18
billion. But the IMF announcement stated that the amount of available
funds was $23 billion. The media have always given the total amount of
the package as $43 billion, including $20 billion of loans coming from
bilateral donors or the ‘second line of defence’.
If the funds readily available from the three multilateral institutions
or first line of defence were $18 billion, then what was the $23 billion? In
fact, the additional $5 billion was Indonesia’s own reserves. This amount
came from the method of calculating reserves that Bank Indonesia used,
which was different from the way the IMF calculated them. The
Indonesian national reserves held by Bank Indonesia to January 1998
were calculated using the concept of ‘official reserves’, while after January
1998 Indonesia adopted the IMF’s concept of ‘gross reserves’. Indonesia’s
official reserves were equal to gross reserves minus some illiquid reserves
(like monetary gold) and those that were highly liquid and therefore very
volatile. At the time of the negotiations with the IMF team in October
1997 the difference between the official reserves and the gross reserves
was $5 billion. This was the amount that was added to the IMF, World
Bank and ADB loans to form the first line of defence of $23 billion. Citing
a large amount of funds as being available may be consistent with the
aim of raising market confidence in the face of increasing demand for
foreign exchange in the market. But this method of calculating the amount
was certainly very confusing.
A note is in order here on the Indonesian government’s use of the
concept of ‘official reserves’. This has been part of a long-time practice of
erring on the conservative side in determining the international reserves
that Bank Indonesia is entrusted by the government to hold. In other
words, it was in the tradition of prudent reserve management.
International reserve holdings are important not just economically in
financing the current account deficit and the deficit on the capital account,
but also psychologically, because exchange rate stability hinges on both
the size and the relative stability of international reserves growth.
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Bank Indonesia and the Recent Crisis
59
Certainly, public confidence in a managed float would be disturbed by
volatility in the international reserves held by the central bank. Based on
this line of reasoning, the basic tenet of reserves management in Indonesia
has been accumulation in a stable growth pattern. To achieve this
objective, official reserves are managed in such a way as to exclude the
volatile components of reserves held by the central bank. The value of
gold is also excluded, since it has historically been the case that liquidating
gold is, psychologically, close to impossible.
In any case, Bank Indonesia’s management of international reserves
holdings had proven constructive in supporting the managed float that
was working so well until the crisis hit. Indonesia had been very prudent
in its reserve management, so that when the IMF arrived there was a
‘surplus’ of $5 billion of foreign exchange arising out of the change from
the concept of official reserves to the IMF method of reserve calculation
to which Bank Indonesia shifted officially in January 1998. The total
amount of reserves available and the conservative method of reporting,
plus prudent use of reserves in market intervention in the early period
of the crisis, put Indonesia in a less precarious position than Thailand or
Korea at the time the decision to seek a standby arrangement was made.
Why, then, has Indonesia’s recovery been so much slower than that
of Thailand and Korea? The problems of the banking sector in these three
countries seem to be similar. The difference lies in the relative size of
their respective external debt and short-term corporate external debt. In
terms of the ratio of total debt to GDP, of total debt to exports or of shortterm external debt to international reserves, Indonesia has been the most
vulnerable. Indonesia also embarked on the resolution of corporate debt
much later and through a much slower process than either Korea or
Thailand.
Even though the condition of the banking industry was similar in the
three countries, the restructuring programs were not identical, in
particular with respect to bank closures. Cole and Slade (1999) point to
substantial differences between the closing of 16 banks in Indonesia and
the suspension of 58 finance companies in Thailand and 14 merchant
banks in Korea. The 16 banks in Indonesia were part of the national
payments system and their closure, which led to public concern that other
bank closures would follow, had a substantial impact on it. In addition,
the bank closures were permanent and settlement was immediate, while
the suspension of finance companies and merchant banks in Thailand
and Korea was not permanent and the settlement was carried out without
immediately affecting the payments system.
Some studies show that the characteristics of the prevailing regime,
as measured by various indicators, play an important role in the duration
and depth of a recession (Hussain and Wihlborg 1999; Pomelearno 1998;
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J. Soedradjad Djiwandono
60
Claessens et al. 1999). This research suggests that the long and deep
recession that Indonesia experienced was to be expected, because of its
high index of corruption, its high concentration of asset ownership, its
low rule-of-law score and its weak creditor-oriented insolvency
procedures.
Furthermore, the problems of Indonesia’s social and political
infrastructure seem to have played a more serious role in the crisis and
its resolution than was the case in Thailand and Korea. These factors
have all contributed to the more precarious nature of Indonesia’s financial
and economic recovery.
SOME CONTROVERSIAL ISSUES
I will not touch on issues during the latter part of the crisis, nor will I
discuss the policies and the challenges for economic recovery. What I
would like to highlight here are some issues relating to the crisis and its
resolution that still arouse controversy: the decision to float the rupiah;
the issue of bank closures; the dilemma of bank rescue using Bank
Indonesia liquidity credits; and the currency board question.
The Dilemma of the Bank Closures
The closure of 16 insolvent banks as the first instalment of the economic
stabilisation program on 1 November 1997 aroused widespread criticism
both domestically and internationally. It may even be correct to say that
criticism of this action (irrespective of whether it is valid or not) was
stronger than that faulting the IMF for giving incorrect advice to
Indonesia, leading it to raise interest rates so high that the economy
collapsed.19
It is certainly ironical that an action originally aimed at restoring
confidence in banking ended up causing that confidence to be almost
totally lost. Various arguments have been launched against the bank
closures of November 1997, including the following.
• For some the action was wrong because Indonesia did not have
any scheme of deposit insurance, and this caused the bank runs
that led to the banking crisis.
• Some argued that there were more weak banks than those being
closed; in other words, more banks should have been closed.
• Some argued that there were banks in a worse position that were
not closed; in other words the policy was unfair, and based on
arbitrary reasoning.
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Bank Indonesia and the Recent Crisis
61
• Still others argued that the bank closures were politically
motivated, aiming to put Soeharto’s family to shame so that he
would not be re-elected President.
The first criticism was seriously advanced by many, including an IMF
director and Professor Jeffrey Sachs.20 I have difficulty in subscribing to
this argument, for the simple reason that any scheme of deposit insurance
only insures a small proportion of deposits. What happened in Indonesia
does not support any contention that there were major problems with
small depositors. Small deposit holders still had some memory of the
closure of Bank Summa in 1992, when all deposits of Rp 10 million or
less were repaid in full, while large depositors were paid in stages as
funds became available from the sale of the bank’s assets.
The government announced in early September 1997 that in the event
of bank closures it would guarantee small deposit holders. In a well
planned national operation to close more than 400 bank offices all over
Indonesia, Bank Indonesia officials, assisted by members of the private
banks association (Perbanas), performed a fine job in repaying more than
800,000 small deposit holders of Rp 20 million or less. It was certainly
not the case, as the IMF’s Dr Boorman alleged in a press conference (see
note 19), that the problems arose from lack of public information from
Bank Indonesia on the deposit guarantee scheme.
The fact was that bank runs happened because large deposit holders
withdrew their funds after losing confidence in the banking system. As
deposit insurance would not normally cover large depositors, it is difficult
to argue that the outcome would have been any different had Indonesia
had a deposit insurance scheme before the bank closures.
On the argument that there were other weak banks besides the 16
that were closed, this is indeed true. However, to argue that more banks
should be closed is definitely not an answer to the loss of confidence
following the closures. In other words, it is absurd to say that the bank
closures would have been more successful—i.e. that there would not have
been bank runs—if a larger number of banks had been closed.21
Part of the public anxiety that led to the panic withdrawal of bank
deposits lay in the fact that the environment was characterised by lack of
transparency, coupled with weak rules on disclosure and weak
governance in both the regulator and the private sector. There was thus
no established yardstick by which the public could evaluate bank status,
and public confidence was very fragile. Meanwhile, in the absence of
reliable official information on banking conditions, some publications
about banking in Indonesia kept reporting on the fragile condition of
national banks, adding to public anxiety.22 In this climate, a process of
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62
J. Soedradjad Djiwandono
‘flight to safety’ occurred, and the banking industry experienced a real
crisis.
Claims that other banks were worse than some being closed, or that
there was political motivation behind the bank closures, were unfounded.
They emerged as a protest from some bank owners who in normal
circumstances would not dare to resort to such absurd arguments.
Were the bank closures of November 1997 a mistake? I think a more
careful analysis still needs to be conducted. However, I would like to
underline here that I subscribe fully to the need to close insolvent banks
as a part of bank restructuring. In fact, I had already submitted a report
to the President recommending closure of a number of banks at the end
of 1996, almost one year before the actual decision to do it. It is true that
the number of banks proposed for closure was less than 16. But all these
banks were among the 16 insolvent banks that were actually closed in
November 1997.23
In general, it can be argued that closing insolvent banks is a must,
but the question of when and how to execute bank closure is critical. The
Indonesian experience teaches us that when public expectations are
fragile, bank closures can produce adverse results. Bank liquidation
should be done when the economy is not fragile, but in general the sooner
the better. This means that the sooner the problem is identified, the sooner
the authorities accept the reality of the issues involved, and the sooner a
well designed resolution is prepared and properly implemented, the
better. This will cost less and hence has a better chance of success.
With the benefit of hindsight, it is clear that these issues were not
taken into account by those involved in the decision, myself included.
My focus in preparing for the bank closures was on how to deal with
payment to small deposit holders, and this was conducted so well by
Bank Indonesia staff that no serious problems occurred—a fact overlooked
by many. As it turned out, it was an irony that the 16 banks were the only
private banks protected from massive deposit withdrawals (Cole and
Slade 1999: 6). The state banks did not experience large deposit
withdrawals. Indeed they gained more deposits, as people moved their
funds from banks perceived to be weak to stronger ones. During the panic,
perception was clearly guiding people’s decisions. It did not matter
whether the perception was supported by substance. If only the public
had been well informed, they would have known that most state banks
were not in a better position than many of the private banks.24
Faced with massive deposit withdrawals, the banking industry was
in crisis indeed. Even though some banks, state banks and foreign banks
in particular, were in a surplus position, they were restricting supply to
the interbank money market to their primary customers. The interbank
money market became compartmentalised and some banks, in particular
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Bank Indonesia and the Recent Crisis
63
weak banks, could not get access to liquidity. Bank Indonesia was forced
to carry out a rescue operation, resorting to the existing mechanisms of
providing liquidity through discount windows and liquidity credits. This
became more pronounced after the President stated publicly, just before
leaving on an overseas trip in late November 1997, that the government
would not close any more banks in the future.
There had been much criticism of Bank Indonesia’s policy of rescuing
banks in distress during the turbulent period after the loss of confidence
in the banking sector. The IMF and other foreign observers criticised Bank
Indonesia’s excessive liquidity expansion in support of banks. Others
criticised the policy by questioning its motivation. Even if these criticisms
were valid, in general they overlooked the fact that, especially after the
government had stated that it would close no more banks, Bank Indonesia
did not have much choice in carrying out its mutually conflicting functions
as lender of last resort and guardian of the payments system on the one
hand, and monetary manager on the other.
The last matter I would like to discuss here is the adoption of a blanket
guarantee or full protection for depositors and creditors towards the end
of January 1998. This decision arose from a suggestion by the IMF team
during the discussions on the second LOI in mid January 1998. Officially
the negotiations were personally conducted by President Soeharto. It
was never clear why this was done. But in part the reason must be that
President Soeharto had by this time become impatient with the way the
crisis was developing; it may also have been because he no longer trusted
the Governor of BI and the Minister of Finance.
I and the other members of the Indonesian team were never
comfortable with agreeing to the government provision to guarantee in
full not just bank deposits and savings but also creditors. But the final
decision was that the full guarantee was for both banks’ liabilities and
their assets, except those belonging to shareholders and holders of
subordinated debts.25 A more serious study should be conducted to
analyse the real impact of the guarantee on the development of
Indonesia’s banking industry. But suffice it here to say that the guarantee
was a desperate policy adopted in the midst of a panic caused by bank
runs and the policy response to them, during the most turbulent period
of the Indonesian crisis.26
It should also be mentioned that one of the two most critical causes
of the Indonesian crisis, namely the problem of unsustainable corporate
debts in foreign currency, was not touched on during the preparation of
the first LOI;27 nor was the question of social safety nets. These two issues
were tackled by the IMF only after strong argument from the Indonesian
team, and following criticism by pundits all over the world of the IMF�
ISSN: 0007-4918 (Print) 1472-7234 (Online) Journal homepage: http://www.tandfonline.com/loi/cbie20
Bank Indonesia and The Recent Crisis
J. Soedradjad Djiwandono
To cite this article: J. Soedradjad Djiwandono (2000) Bank Indonesia and The Recent Crisis,
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Bulletin of Indonesian Economic Studies
Vol 36 No 1, April 2000, pp. 47–72
BANK INDONESIA AND THE RECENT CRISIS
J. Soedradjad Djiwandono*
University of Indonesia and
Harvard Institute for International Development
This paper is a personal note describing the crisis as it unfolded while the
writer was a key player in Indonesia’s macroeconomic management. The
crisis is seen as multi-faceted. It originated externally from a shock in the
currency market that triggered a downward spiral from currency
depreciation to fully-fledged crisis. The currency shock that hit the rupiah
in July 1997 exposed in sequence the flaws embedded in the banking sector,
the economic system, the social and the political system, flaws that had
been obscured by long years of good economic performance. Through a
complicated process of contagion and feedback effects—market
disturbances, policy responses and market reactions—Indonesia
deteriorated from a relatively well managed economy to the ‘worst case’
among the Asian crisis economies. The paper discusses this process, the
IMF’s role, the bank closure issue, the currency board controversy and
the author’s dismissal as Governor of Bank Indonesia.
INTRODUCTION
The Indonesian crisis is now more than two years old, yet there has not
been a clear signal that the economy is truly heading toward recovery,
let alone sustainable, balanced and broad-based development. Following
the much better than expected general election of 7 June 1999, there were
encouraging developments in the economy and in the social and political
spheres as macro indicators improved. However, this did not last long
enough to support a more sustained path toward recovery and growth.
Expectations arising from both external developments and domestic
events produced a recurrence of economic strains, resulting in further
pressures on the rupiah and on equity prices.
Of the three worst hit crisis countries in Asia, Indonesia’s recovery is
by far the slowest. Thailand and especially Korea seem to have remained
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48
J. Soedradjad Djiwandono
on a steady path of recovery. The latest developments confirm that
Indonesia is the ‘worst case’ among the Asian crisis economies. More
careful analysis is needed to explain the peculiar character of the
Indonesian crisis.
This paper is a personal assessment of the Indonesian crisis from the
vantage point of my position as Governor of Bank Indonesia during a
critical part of the crisis period. I would like to offer my recollections of
how the crisis developed from an external shock in the currency market,
rapidly spreading wider and deeper in a complicated process of contagion
to become a fully-fledged crisis, through the impact of shocks, policy
responses and market reactions. The period of the crisis from its beginning
in mid July 1997 to the time of my untimely departure from office in mid
February 1998 may be the most confusing part of Indonesia’s history of
economic policy management, and deserves to be documented for future
scrutiny.
THE CRISIS AND ITS IMPLICATIONS
There have been many conferences and writings on the Asian crisis,
discussing its nature and causes, its implications, and the lessons to be
learned from it. One can be sure that such studies will continue in the
years to come. This is because, despite the attention it has received, the
crisis has persisted for longer than expected, and its effects have been
more devastating than most people would be prepared to accept. The
Asian crisis has been followed by the Russian and Brazilian crises.
Recent developments seem to suggest that the crisis is over, or close
to over, and most people agree that it is generally behind us. For example,
at the Interim Committee Meeting of the International Monetary Fund
(IMF) in the northern spring of 1999 it was reported that, of the three
hardest hit countries in Asia, Korea was experiencing a recovery, the Thai
crisis was bottoming out, and Indonesia was following suit. Brazil was
considered to be out of the crisis, while Russia was close to having a new
IMF-supported program. The ‘Survey of Recent Developments’ in the
August 1999 issue of BIES (Pardede 1999) presented a similar view of
Indonesia’s progress.
But more recent developments in Indonesia, and to a certain degree
also in Thailand, have raised new concerns (Krugman 1999; Arnold 1999).
The still fragile recovery in some crisis countries has been challenged by
new problems arising from the expectation and ultimate implementation
of an interest rate hike in the US, and from the new fear of a yuan
devaluation. In Indonesia, the good news about a much better than
expected general election was tainted by the Bank Bali scandal and the
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Bank Indonesia and the Recent Crisis
49
atrocities in East Timor, which immediately put pressure on the rupiah
and on equity prices.1
Views on the causes of the crisis are many. However, over time some
consensus seems to be developing. Differences might be narrowed down
to two perspectives, which could be distinguished much as we
differentiate between the Classical and the Keynesian economists’ views
on the workings of the market. With respect to the Asian crisis, we could
distinguish between those who see its origin as domestic and those who
view it as originating externally. The first group argues that the crisis
arose from practices of crony capitalism and weak financial structures,
together with inept macro policies; the second group sees it as triggered
by a shift of sentiment in the financial market that caused a contagious
process of financial panic. The first view, put by people such as Professor
Krugman of MIT, could be considered as a structural explanation of the
crisis (Krugman 1998). The second view argues that the crisis was
essentially a case of financial panic in the Keynesian tradition, as
succinctly explained by Professor Kindleberger in his seminal work two
decades ago (Kindleberger 1996). Professor Jeffrey Sachs has been the
major proponent of this view (Radelet and Sachs 1998).
As one who had first-hand experience of the crucial part of the
Indonesian crisis, I would argue that it was not determined by one single
variable, whether external or domestic in origin. It is my view that the
Asian crisis, and in particular the Indonesian crisis, arose from a
combination of the workings of ‘contagion’ forces from outside the
national economy on the one hand and weak domestic economic and
financial structures on the other. The contagion factor emanated from a
sudden change in market sentiment in the region that led to a shock in
its currency markets. This resulted in panic selling of local currencies,
and of other assets denominated in local currencies, for dollars.
The rapid downgrading of the region’s sovereign credit ratings by
international rating agencies further fuelled the shift in market sentiment,
triggering panic selling of foreign-owned local assets. In the media, the
term ‘Asian miracle’ disappeared suddenly, to be replaced by ‘Asian crisis’
or ‘Asian meltdown’. But the most telling sign was the Institute of
International Finance’s publication on capital flows for Thailand,
Malaysia, Indonesia, the Philippines and South Korea. The estimates
showed a reversal in flows of capital of $105 billion in these five countries
in a single year, from inflows of $93 billion in 1996 to outflows of $12
billion in 1997. For Indonesia alone, the reversed capital flow was
estimated at $22 billion, from inflows of $10 billion to outflows of $12
billion. This was indeed a financial panic in the Keynesian tradition, as
explained by Kindleberger (1996).
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50
J. Soedradjad Djiwandono
But the external shock itself need not have caused a crisis of the
magnitude that these countries suffered, if only their domestic economic,
social and political structures had been robust. Confronted with a
contagious external shock the Indonesian economy, with its embedded
inefficiencies and weak financial system, could not withstand its impact.2
The domino effect of the weakening rupiah adversely affected the
financial sector, and then the real sector of the national economy. Thus, a
combination of severe external shock triggered by changes in market
sentiment, and financial-cum-real sector structural weaknesses, caused
a contagious process that severely damaged the entire economy.
The Indonesian crisis developed as a sequence of events which began
with an external shock—part of a contagious financial panic in the
region—that hit Jakarta’s financial market. The shock, the policy response
and the market reaction exposed the fragility of the national banking
system, leading to a banking crisis. In turn, the banking crisis seeped
through the payment system, revealing weaknesses in the real sector of
the national economy—which was basically a system of ‘ersatz capitalism’
in Yoshihara’s characterisation (Yoshihara 1988), with embedded
inefficiencies and widespread corruption—and led to an economic crisis.3
The economic crisis exposed institutional weaknesses in Indonesia’s social
and political system. In a complex and intertwined set of relationships,
with feedback effects, the financial crisis turned rapidly into a multifaceted crisis, crippling not just the national economy, but society and
politics as well.
Many argue that the Asian crisis stands out as one of the major crises
since the depression of the 1930s. Its impact has been so devastating that
even pessimists acknowledge it has been worse than they expected.
Indonesia, Thailand and South Korea have suffered more severely than
other countries. And it is becoming apparent that, of the three, Indonesia
has suffered the most in terms of the decline in economic growth, the
depreciation of the currency, social dislocation and other problems.
The virulent nature of the Indonesian crisis has been well documented.
Its chief features may be summarised as follows.
• The economic deterioration has been devastating. A single year
(1998) saw the drastic reversal of a long period of high GDP growth
rates, from 7–8% annually to negative growth of close to 14%; a
50% cut in income per capita in dollar terms; a sizeable reversal
in private capital flows (the estimates range between $25 and $40
billion); a jump in the inflation rate from single digits to 80%; and
an 80% depreciation in the rupiah in less than 12 months.
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Bank Indonesia and the Recent Crisis
51
• The social and political impacts have also been severe. They
include a dramatic rise in unemployment, especially in urban areas
of Java—some estimates put the figure at more than 5 million
additional people unemployed; a drastic increase in the number
of people living below the poverty line, from 11% to close to 25%
of the total population in 1998; a large rise in school dropouts at
all levels of schooling; an increase in the rate of petty crime and
prostitution; and other social problems.4
• Aside from the horrors reported in Ambon, West Kalimantan, East
Timor and elsewhere, there have been other indications of social
disintegration. In addition to the infamous riots that caused the
death of more than 1,100 people and the burning of houses, looting
and rapes in May 1997, Crosby Corporate Advisory reported that
in 1998 there were nearly 2,000 student demonstrations; 1,300
rallies by non-government groups; 500 strikes; and 50 riots.5
• The crisis forced Soeharto, who had ruled the country for 32 years,
to resign in disgrace. He was succeeded by his close protégé, Dr
Habibie, who served as President from 21 May 1998 until October
1999, when the MPR elected Abdurrahman Wahid as the new
President.
It is my conviction that the Indonesian crisis originated from an
ordinary currency problem, when the rupiah suffered from sudden
pressure in July 1997 after the floating of the Thai baht earlier that month.
However, after a sequence of policy responses by the government and
market reaction thereafter, the problems spread rapidly and deeply to
affect all sectors of the national economy, before finally impacting on
politics.6
POLICY RESPONSES AND MARKET REACTIONS
Faced with the currency shock in early July 1997, the government took a
decision to widen Bank Indonesia’s intervention bands on 11 July. It was
almost a routine exercise, since Bank Indonesia had done this a number
of times before. This decision was lauded by many, including
representatives of donor countries at the CGI (Consultative Group on
Indonesia) meeting in Tokyo several days later. Some papers reported
Bank Indonesia’s step as a ‘preemptive’ measure.
Market reaction was not as expected, however; in fact it was the
reverse of previous experience. In the past, whenever Bank Indonesia
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J. Soedradjad Djiwandono
had widened the bands, the rupiah had appreciated, and the dollar spot
exchange rate had closely followed Bank Indonesia’s buying rate. But
this time the rupiah depreciated after the bands were widened. The dollar
spot rate not only broke through the mid rate, it also broke through the
selling rate or upper band. What happened in July 1997 was different
from previous periods of pressure in the currency market. A contagion
effect was in progress.7 Since investors were convinced, partly by rating
agencies and financial analysts, of the presence of similar structural
weaknesses within the economies in the region, their ‘herd instinct’
dictated that they should move their investments out of Asia.
When the spot rate broke BI’s selling rate the central bank intervened
in the market, first by selling dollars forward, and later in the spot market.
Market intervention from the third week of July until the day before the
rupiah was floated in the spot market amounted to $1.5 billion.8 When
these efforts did not stabilise the rupiah, and given that it was now the
only currency in the region that was not freely floating, the government
decided to free float the rupiah on 14 August 1997.
This was supported by monetary tightening through the raising of
interest rates and sterilisation and by fiscal tightening. Bank Indonesia
had already reduced bank liquidity in late July by ceasing to allow banks
to rediscount their own papers (SBPUs). But a more stringent step was
taken in mid August, when the central bank raised the rates for some BI
certificates (SBIs) to at least double their previous level. For example, the
one-week SBI rate was raised from 10.5% to 20%, and the three-month
rate from 11.5% to 28%. On 29 August Bank Indonesia also issued a new
rule limiting the forward sale of dollars to non-residents to $5 million, to
reduce currency speculation.
On the fiscal side, the Minister of Finance cut government spending
by rescheduling some projects and limiting routine expenditures on nonpriority items. He also instructed a number of state enterprises and
foundations to transfer their bank deposits of Rp 3.5 trillion to SBI
holdings.9
But following the shock, the policy response and the market reaction,
a new phenomenon developed. In reaction to the monetary and fiscal
tightening, the weak banking sector began to suffer distress. Bank runs
emerged as early as the second half of August 1997, when the process of
‘flight to safety’ began. And the interbank money market became
compartmentalised, with ‘suspect’ banks having to pay much higher
interest rates to borrow from other banks. Interbank rates increased
dramatically, from an average of 22% to more than 80%. There was even
an occasion when the overnight interbank rate reached 200% per annum.
By the end of August 1997, more than 50 banks had failed to comply
with the minimum reserve requirement of 5%.
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Bank Indonesia and the Recent Crisis
53
Realising that the problem had spread to the banking sector, the
government launched a broad economic policy initiative on 3 September
1997. The policy package encompassed not just monetary and fiscal
measures, but also steps in the real sector, in the form of further trade
liberalisation steps and the rescheduling of government projects with
high import content. The government promised to continue adhering to
an open foreign exchange policy. With respect to the banking sector, it
announced steps that included a promise to keep helping solvent banks
facing liquidity problems, a more active effort to encourage bank mergers,
and a policy of closing insolvent banks, with a pledge to take care of
small deposit holders’ interests with state banks.10
Despite all these efforts, not much progress was made in stabilising
the currency or containing the banking problem. In the process, more
banks became unable to comply with the minimum reserve requirement,
and some even began to have a negative balance with Bank Indonesia.
The economic team in the government was convinced that Indonesia
was facing a confidence problem. A concerted effort had to be made to
restore confidence. This led to the idea of seeking International Monetary
Fund assistance to boost market confidence. The preliminary discussions
on inviting an IMF team were held when Dr Stanley Fischer, First Deputy
Managing Director of the Fund, visited Jakarta at the invitation of the
Minister of Finance, on his way to the 1997 Annual Meetings of the World
Bank and the IMF in Hong Kong. This happened some time in mid
September 1997.
During the meeting with Dr Fischer, I proposed a precautionary
arrangement with the Fund, instead of a fully-fledged standby
arrangement. This idea was pursued further in Washington, but it was
pushed aside during the follow-up discussions between the IMF team
headed by the Fund’s Director for the Asia–Pacific, Hubert Neiss, and
Minister Mar’ie Muhammad and myself, during the annual meetings in
Hong Kong. Because of the rapid deterioration in Indonesia’s financial
position, the discussion shifted rapidly to a standby arrangement.
My original preference for a precautionary rather than a standby
arrangement was based on a conviction that our economic circumstances
were not so bad, at least in terms of the foreign exchange reserves that BI
held at that time. I would still argue that this is true. Thailand and Korea
were in a much worse position in terms of their reserve holdings at the
time the Fund was invited in. Our problem then was to restore market
confidence, and this objective could be well served by the presence of
the IMF under a precautionary arrangement. But a more important reason
was that I was afraid I would not be able to persuade the President to
agree to the stringent conditionality of a standby arrangement. A
precautionary arrangement would bear much less stringent conditions,
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54
J. Soedradjad Djiwandono
even though it did not automatically include funds. Funding was not
our major problem—at least that was how I looked at the circumstances
then. 11 The most crucial issue was the lack of market confidence in
macroeconomic management, which would have been restored through
IMF support of government policy. In the past, other countries like India
and South Korea had been successful in addressing their problems
through IMF precautionary arrangements.
The IMF-supported program for Indonesia summarised in the
Memorandum on Economic and Financial Policies (MEFP) was submitted
to the Fund via a letter of intent (LOI) on 31 October 1997. The program
comprised a package of policies for economic reform in both the real and
the financial sector, supported by prudent monetary and fiscal policy.
The monetary and fiscal measures consisted of standard programs of
macroeconomic management to stabilise the exchange rate and other
monetary variables.
The core of the program was a policy package to deal with insolvent
and weak banks and strengthen financial infrastructures, and to overcome
structural rigidities in the real sector of the national economy. Thus, the
framework was put in place for a comprehensive policy to restore
confidence and arrest the decline of the rupiah. In essence, the program
was built around three areas:12
• a strong macroeconomic framework designed to achieve an
orderly adjustment in the external current account, incorporating
substantial government spending cuts and a tight monetary
stance;
• a comprehensive strategy to restructure the financial sector,
including early closing of insolvent institutions; and
• a broad range of structural measures to improve governance in
the government as well as the corporate sector.
Initially, the implementation of the program received a positive
response from the market, the external market in particular. The closing
of 16 insolvent banks, and joint intervention in the currency market by
Bank Indonesia, the Monetary Authority of Singapore and the Bank of
Japan, were welcomed by the external market, and resulted in a
strengthening of the rupiah, which for a while rose from Rp 3,700
to Rp 3,200/$.
However, the domestic reaction to the closing of banks was the reverse
of what was expected. It was ironic that a step designed to restore
confidence in the banking sector instead resulted in a collapse of
confidence, plunging the sector into chaos. It continued to suffer from a
process of ‘flight to safety’, with bank runs becoming common. Many
banks lost their deposit base, and the interbank money market became
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Bank Indonesia and the Recent Crisis
55
seriously compartmentalised. In addition, from January 1998 many banks
found that trade and other financial lines from their bank business abroad
were terminated. Letters of credit issued by many Indonesian banks were
not accepted overseas. This plunged the banking sector from a state of
distress into a state of crisis, with market confidence almost completely
lost.13
After some ‘flip-flop’ implementation of the IMF-supported program,
the confidence problem shifted from being just an economic problem to
being one of national leadership. The negative reaction to the IMFsupported reform program became more pronounced when the loss of
confidence caused by the bank closures was further complicated by a
government announcement to reverse a decision to postpone several large
government projects. At about the same time, monopoly practices and
other inconsistencies reappeared in the implementation of the program
for restructuring the real sector. In this way market confidence in the
government’s commitment to the economic restructuring program
evaporated. As a result, not only was the rupiah’s slide difficult to stop,
but the economic crisis was spiralling into a ‘total crisis’.
SOME NOTES ON THE IMF-SUPPORTED PROGRAM
With the crisis now more than two years old, policy responses to the
problems and market reactions, including feedback responses, can be
better understood with the benefit of hindsight. Some comparisons can
also be drawn with the experience of other countries in Asia. It should be
noted here that, even though we tend to treat problems in the crisis
countries as similar, they are not identical, since each crisis has its own
peculiarities. Indonesia, despite its relatively better conditions and better
early policy response, has ultimately become the worst case among the
countries experiencing crisis, and the slowest in its path towards recovery.
Among Asia’s crisis countries, Thailand, Indonesia and Korea all
sought IMF support, while other countries in Asia did not. Malaysia faced
the crisis on its own, including resorting to capital controls, even though
before being sacked Minister of Finance Anwar Ibrahim was known to
subscribe to stringent policies in the IMF tradition. Meanwhile, the
Philippines had been on precautionary arrangements with the IMF for
some time.
Thailand signed its first letter of intent on 2 July, Indonesia on 31
October, and Korea on 1 December, all in 1997. Each of these countries
was granted standby support under the Emergency Financial Mechanism
(EFM), introduced a year earlier to hasten the decision making processes
of the IMF’s Board and the disbursement of loans. Korea was the first
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J. Soedradjad Djiwandono
country to receive a standby loan based on the newly modified EFM
with its faster disbursement mechanism. All these programs have two
types of funding sources, namely the ‘first line of defence’, comprising
IMF, World Bank and Asian Development Bank (ADB) loans, and the
‘second line of defence’, consisting of bilateral loans from countries
attached to these programs.
Before seeking IMF support, all three countries had been dealing with
strong pressure on their respective currencies by resorting to their own
means of foreign exchange management. They began their defence against
the currency onslaught by way of intervention in the foreign exchange
market, in line with their adherence to a pegged system of foreign
exchange management—a rigid pegged system in the case of Thailand
and Korea, and a managed float in the case of Indonesia. After losing
substantial reserves in market intervention, particularly in the first two
countries, one by one the three abandoned their pegged systems, and
moved to a floating foreign exchange system. But when market confidence
was shaken, each sought IMF support in an effort to restore market
confidence.
In general, an IMF-supported program contains adjustment policies
that a country promises to adopt to deal with imbalances from a shock or
crisis. Since the Asian crisis is multifaceted, reflecting a variety of problems
and weaknesses, a sustainable program to address the problems of the
crisis effectively must also comprise several aspects. There has been much
criticism of the IMF’s handling of the Asian crisis. Its general thrust is
that this crisis is not typical of the problems the IMF was set up to deal
with. On the whole, the Asian crisis countries have not suffered from
budget deficits, hyperinflation or even chronic balance of payments
deficits. Yet the IMF therapy, at least the one usually emphasised, is a
tight money policy with sky-high interest rates. There is some truth in
this criticism, even if it is not entirely valid. Among the many factors
causing or contributing to the crisis in Asia, the important common
elements in the crisis-affected countries are a weak banking or financial
system and unsustainable corporate short-term debt in foreign currencies.
No stabilisation and recovery program will be effective in solving the
crisis unless it seriously addresses these two problems.
There are slight variations in each country, but generally the IMFsupported programs adopted to face the crisis comprised financial reform
and economic restructuring, complemented by prudent monetary and
fiscal policy. The classic IMF approach is, of course, monetary and fiscal
policy to address monetary instabilities, like inflation and balance of
payments problems, and fiscal imbalances. But its capacity to deal with
problems of economic structure, such as monopolies and oligopolies and
the practices of crony capitalism, granted that these are real issues in the
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Bank Indonesia and the Recent Crisis
57
countries concerned, has raised controversy. Measures to address
problems of bank restructuring and corporate debt have also drawn
criticism. It is important to acknowledge that in all these cases the Fund
has worked together with its sister institutions, the World Bank and the
ADB, to mobilise a pool of expertise to deal with these complex problems.
Since the fundamental problem facing these countries is one of market
confidence, the presence of the multilateral agencies is crucial. They must
show their support of these countries’ adjustment programs through their
expertise, but also through the provision of significant funds that can be
speedily drawn. Hence, the Emergency Financial Mechanism and the
huge magnitude of the loans.14
Thailand’s standby loan from the Fund was $4 billion, which
constituted 505% of its quota. Indonesia’s original loan was $10 billion,
or 490% of its quota.15 In July 1998 an additional $1.5 billion loan was
approved, making the total more than 500% of Indonesia’s quota. Korea’s
loan of $21 billion amounted to 1,939% of its quota (Lane et al. 1999). In
addition, each country also acquired loans from the World Bank and the
ADB, which could be drawn relatively quickly. Likewise, each received
some lines of credit from bilateral countries, which were linked to the
IMF standby facility. In general, these loans could only be used when
sources from the multilateral institutions had been exhausted, hence their
status as a second line of defence.
The practice of maximising the apparent magnitude of loans in the
context of an IMF standby arrangement, by including loans from different
countries in the package as part of a second line of defence, has not been
very meaningful in confidence building.16 The market is not easily
impressed with these numbers, and most market players know how
difficult it is for recipient countries to cash in the second line of defence
facilities.17 On the other hand, since the media always used these higher
numbers, in the case of Indonesia the well known phrase ‘the $43 billion
IMF-bail out’ may have given the wrong impression to an uninformed
public, at least about the size of the national debt.
In a way, since the original purpose of acquiring IMF support was to
restore market confidence, the availability of lines of credit from bilateral
donors may have provided creditors and investors of the recipient
countries with some sense of security in their respective claims. These
credit lines would certainly cushion the reserves held by the countries
accepting IMF support. If creditors and investors were convinced, then
this would reduce the demand for foreign exchange. It would also reduce
the pressure for creditor countries to stop providing trade financing and
money lines to the Indonesian banking community. And this could
happen without the recipient countries drawing on the facilities provided
in the scheme. However, if the program were not acceptable to creditors
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J. Soedradjad Djiwandono
and investors, as was the Indonesian case, the pressure to withdraw
existing loans would remain, and the demand for foreign exchange in
the market would keep rising. Indonesia’s experience with the gimmick
of describing the program as a huge ‘IMF bail-out’ was that it did not
seem to contribute to the objective of restoring market confidence in the
banking sector and in macroeconomic management.18
I should also mention that there was never a clear statement of the
amount of ‘first line of defence’ assistance available to Indonesia when
the IMF agreed to provide a loan in support of a standby arrangement
based on the 31 October 1997 LOI. It was announced that the amount of
the IMF loan was $10.5 billion. If this amount is added to the World Bank
and ADB loans of $7.5 billion, the amount readily available becomes $18
billion. But the IMF announcement stated that the amount of available
funds was $23 billion. The media have always given the total amount of
the package as $43 billion, including $20 billion of loans coming from
bilateral donors or the ‘second line of defence’.
If the funds readily available from the three multilateral institutions
or first line of defence were $18 billion, then what was the $23 billion? In
fact, the additional $5 billion was Indonesia’s own reserves. This amount
came from the method of calculating reserves that Bank Indonesia used,
which was different from the way the IMF calculated them. The
Indonesian national reserves held by Bank Indonesia to January 1998
were calculated using the concept of ‘official reserves’, while after January
1998 Indonesia adopted the IMF’s concept of ‘gross reserves’. Indonesia’s
official reserves were equal to gross reserves minus some illiquid reserves
(like monetary gold) and those that were highly liquid and therefore very
volatile. At the time of the negotiations with the IMF team in October
1997 the difference between the official reserves and the gross reserves
was $5 billion. This was the amount that was added to the IMF, World
Bank and ADB loans to form the first line of defence of $23 billion. Citing
a large amount of funds as being available may be consistent with the
aim of raising market confidence in the face of increasing demand for
foreign exchange in the market. But this method of calculating the amount
was certainly very confusing.
A note is in order here on the Indonesian government’s use of the
concept of ‘official reserves’. This has been part of a long-time practice of
erring on the conservative side in determining the international reserves
that Bank Indonesia is entrusted by the government to hold. In other
words, it was in the tradition of prudent reserve management.
International reserve holdings are important not just economically in
financing the current account deficit and the deficit on the capital account,
but also psychologically, because exchange rate stability hinges on both
the size and the relative stability of international reserves growth.
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Bank Indonesia and the Recent Crisis
59
Certainly, public confidence in a managed float would be disturbed by
volatility in the international reserves held by the central bank. Based on
this line of reasoning, the basic tenet of reserves management in Indonesia
has been accumulation in a stable growth pattern. To achieve this
objective, official reserves are managed in such a way as to exclude the
volatile components of reserves held by the central bank. The value of
gold is also excluded, since it has historically been the case that liquidating
gold is, psychologically, close to impossible.
In any case, Bank Indonesia’s management of international reserves
holdings had proven constructive in supporting the managed float that
was working so well until the crisis hit. Indonesia had been very prudent
in its reserve management, so that when the IMF arrived there was a
‘surplus’ of $5 billion of foreign exchange arising out of the change from
the concept of official reserves to the IMF method of reserve calculation
to which Bank Indonesia shifted officially in January 1998. The total
amount of reserves available and the conservative method of reporting,
plus prudent use of reserves in market intervention in the early period
of the crisis, put Indonesia in a less precarious position than Thailand or
Korea at the time the decision to seek a standby arrangement was made.
Why, then, has Indonesia’s recovery been so much slower than that
of Thailand and Korea? The problems of the banking sector in these three
countries seem to be similar. The difference lies in the relative size of
their respective external debt and short-term corporate external debt. In
terms of the ratio of total debt to GDP, of total debt to exports or of shortterm external debt to international reserves, Indonesia has been the most
vulnerable. Indonesia also embarked on the resolution of corporate debt
much later and through a much slower process than either Korea or
Thailand.
Even though the condition of the banking industry was similar in the
three countries, the restructuring programs were not identical, in
particular with respect to bank closures. Cole and Slade (1999) point to
substantial differences between the closing of 16 banks in Indonesia and
the suspension of 58 finance companies in Thailand and 14 merchant
banks in Korea. The 16 banks in Indonesia were part of the national
payments system and their closure, which led to public concern that other
bank closures would follow, had a substantial impact on it. In addition,
the bank closures were permanent and settlement was immediate, while
the suspension of finance companies and merchant banks in Thailand
and Korea was not permanent and the settlement was carried out without
immediately affecting the payments system.
Some studies show that the characteristics of the prevailing regime,
as measured by various indicators, play an important role in the duration
and depth of a recession (Hussain and Wihlborg 1999; Pomelearno 1998;
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J. Soedradjad Djiwandono
60
Claessens et al. 1999). This research suggests that the long and deep
recession that Indonesia experienced was to be expected, because of its
high index of corruption, its high concentration of asset ownership, its
low rule-of-law score and its weak creditor-oriented insolvency
procedures.
Furthermore, the problems of Indonesia’s social and political
infrastructure seem to have played a more serious role in the crisis and
its resolution than was the case in Thailand and Korea. These factors
have all contributed to the more precarious nature of Indonesia’s financial
and economic recovery.
SOME CONTROVERSIAL ISSUES
I will not touch on issues during the latter part of the crisis, nor will I
discuss the policies and the challenges for economic recovery. What I
would like to highlight here are some issues relating to the crisis and its
resolution that still arouse controversy: the decision to float the rupiah;
the issue of bank closures; the dilemma of bank rescue using Bank
Indonesia liquidity credits; and the currency board question.
The Dilemma of the Bank Closures
The closure of 16 insolvent banks as the first instalment of the economic
stabilisation program on 1 November 1997 aroused widespread criticism
both domestically and internationally. It may even be correct to say that
criticism of this action (irrespective of whether it is valid or not) was
stronger than that faulting the IMF for giving incorrect advice to
Indonesia, leading it to raise interest rates so high that the economy
collapsed.19
It is certainly ironical that an action originally aimed at restoring
confidence in banking ended up causing that confidence to be almost
totally lost. Various arguments have been launched against the bank
closures of November 1997, including the following.
• For some the action was wrong because Indonesia did not have
any scheme of deposit insurance, and this caused the bank runs
that led to the banking crisis.
• Some argued that there were more weak banks than those being
closed; in other words, more banks should have been closed.
• Some argued that there were banks in a worse position that were
not closed; in other words the policy was unfair, and based on
arbitrary reasoning.
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Bank Indonesia and the Recent Crisis
61
• Still others argued that the bank closures were politically
motivated, aiming to put Soeharto’s family to shame so that he
would not be re-elected President.
The first criticism was seriously advanced by many, including an IMF
director and Professor Jeffrey Sachs.20 I have difficulty in subscribing to
this argument, for the simple reason that any scheme of deposit insurance
only insures a small proportion of deposits. What happened in Indonesia
does not support any contention that there were major problems with
small depositors. Small deposit holders still had some memory of the
closure of Bank Summa in 1992, when all deposits of Rp 10 million or
less were repaid in full, while large depositors were paid in stages as
funds became available from the sale of the bank’s assets.
The government announced in early September 1997 that in the event
of bank closures it would guarantee small deposit holders. In a well
planned national operation to close more than 400 bank offices all over
Indonesia, Bank Indonesia officials, assisted by members of the private
banks association (Perbanas), performed a fine job in repaying more than
800,000 small deposit holders of Rp 20 million or less. It was certainly
not the case, as the IMF’s Dr Boorman alleged in a press conference (see
note 19), that the problems arose from lack of public information from
Bank Indonesia on the deposit guarantee scheme.
The fact was that bank runs happened because large deposit holders
withdrew their funds after losing confidence in the banking system. As
deposit insurance would not normally cover large depositors, it is difficult
to argue that the outcome would have been any different had Indonesia
had a deposit insurance scheme before the bank closures.
On the argument that there were other weak banks besides the 16
that were closed, this is indeed true. However, to argue that more banks
should be closed is definitely not an answer to the loss of confidence
following the closures. In other words, it is absurd to say that the bank
closures would have been more successful—i.e. that there would not have
been bank runs—if a larger number of banks had been closed.21
Part of the public anxiety that led to the panic withdrawal of bank
deposits lay in the fact that the environment was characterised by lack of
transparency, coupled with weak rules on disclosure and weak
governance in both the regulator and the private sector. There was thus
no established yardstick by which the public could evaluate bank status,
and public confidence was very fragile. Meanwhile, in the absence of
reliable official information on banking conditions, some publications
about banking in Indonesia kept reporting on the fragile condition of
national banks, adding to public anxiety.22 In this climate, a process of
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J. Soedradjad Djiwandono
‘flight to safety’ occurred, and the banking industry experienced a real
crisis.
Claims that other banks were worse than some being closed, or that
there was political motivation behind the bank closures, were unfounded.
They emerged as a protest from some bank owners who in normal
circumstances would not dare to resort to such absurd arguments.
Were the bank closures of November 1997 a mistake? I think a more
careful analysis still needs to be conducted. However, I would like to
underline here that I subscribe fully to the need to close insolvent banks
as a part of bank restructuring. In fact, I had already submitted a report
to the President recommending closure of a number of banks at the end
of 1996, almost one year before the actual decision to do it. It is true that
the number of banks proposed for closure was less than 16. But all these
banks were among the 16 insolvent banks that were actually closed in
November 1997.23
In general, it can be argued that closing insolvent banks is a must,
but the question of when and how to execute bank closure is critical. The
Indonesian experience teaches us that when public expectations are
fragile, bank closures can produce adverse results. Bank liquidation
should be done when the economy is not fragile, but in general the sooner
the better. This means that the sooner the problem is identified, the sooner
the authorities accept the reality of the issues involved, and the sooner a
well designed resolution is prepared and properly implemented, the
better. This will cost less and hence has a better chance of success.
With the benefit of hindsight, it is clear that these issues were not
taken into account by those involved in the decision, myself included.
My focus in preparing for the bank closures was on how to deal with
payment to small deposit holders, and this was conducted so well by
Bank Indonesia staff that no serious problems occurred—a fact overlooked
by many. As it turned out, it was an irony that the 16 banks were the only
private banks protected from massive deposit withdrawals (Cole and
Slade 1999: 6). The state banks did not experience large deposit
withdrawals. Indeed they gained more deposits, as people moved their
funds from banks perceived to be weak to stronger ones. During the panic,
perception was clearly guiding people’s decisions. It did not matter
whether the perception was supported by substance. If only the public
had been well informed, they would have known that most state banks
were not in a better position than many of the private banks.24
Faced with massive deposit withdrawals, the banking industry was
in crisis indeed. Even though some banks, state banks and foreign banks
in particular, were in a surplus position, they were restricting supply to
the interbank money market to their primary customers. The interbank
money market became compartmentalised and some banks, in particular
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Bank Indonesia and the Recent Crisis
63
weak banks, could not get access to liquidity. Bank Indonesia was forced
to carry out a rescue operation, resorting to the existing mechanisms of
providing liquidity through discount windows and liquidity credits. This
became more pronounced after the President stated publicly, just before
leaving on an overseas trip in late November 1997, that the government
would not close any more banks in the future.
There had been much criticism of Bank Indonesia’s policy of rescuing
banks in distress during the turbulent period after the loss of confidence
in the banking sector. The IMF and other foreign observers criticised Bank
Indonesia’s excessive liquidity expansion in support of banks. Others
criticised the policy by questioning its motivation. Even if these criticisms
were valid, in general they overlooked the fact that, especially after the
government had stated that it would close no more banks, Bank Indonesia
did not have much choice in carrying out its mutually conflicting functions
as lender of last resort and guardian of the payments system on the one
hand, and monetary manager on the other.
The last matter I would like to discuss here is the adoption of a blanket
guarantee or full protection for depositors and creditors towards the end
of January 1998. This decision arose from a suggestion by the IMF team
during the discussions on the second LOI in mid January 1998. Officially
the negotiations were personally conducted by President Soeharto. It
was never clear why this was done. But in part the reason must be that
President Soeharto had by this time become impatient with the way the
crisis was developing; it may also have been because he no longer trusted
the Governor of BI and the Minister of Finance.
I and the other members of the Indonesian team were never
comfortable with agreeing to the government provision to guarantee in
full not just bank deposits and savings but also creditors. But the final
decision was that the full guarantee was for both banks’ liabilities and
their assets, except those belonging to shareholders and holders of
subordinated debts.25 A more serious study should be conducted to
analyse the real impact of the guarantee on the development of
Indonesia’s banking industry. But suffice it here to say that the guarantee
was a desperate policy adopted in the midst of a panic caused by bank
runs and the policy response to them, during the most turbulent period
of the Indonesian crisis.26
It should also be mentioned that one of the two most critical causes
of the Indonesian crisis, namely the problem of unsustainable corporate
debts in foreign currency, was not touched on during the preparation of
the first LOI;27 nor was the question of social safety nets. These two issues
were tackled by the IMF only after strong argument from the Indonesian
team, and following criticism by pundits all over the world of the IMF�