Consider the following "fundamentals" in 1996: the country's real GDP grew by 7.8%, inflation declined to 6.5%, the current account deficit was less-than 4% of GDP (the lowest among the ASEAN-4), the government budget was in balance with even a slight surplus, and foreign reserves could finance 5 months of imports. The most recent estimate shows that even for the first two quarters of 1997, the GDP growth was over 7%.

Serious faults could hardly be found on the macroeconomic front. Indeed, the country's macroeconomic stand has been quite healthy with tight fiscal and prudent monetary policies. Until the decision to float the rupiah was made on August 14, the exchange rate situation had also improved, becoming more market-determined as evidenced from the periodically increasing intervention band (the latest being 12%). With such a record, very few economists would allude to "weak fundamentals." Surely none would predict a collapse.

What Went Wrong?

The financial crisis evolved in stages. In the first stage, the devaluation of the Thai's baht on July 2 created a serious jitteriness among global investors. Mutual fund managers and corporate treasurers from around the world, not only in Thailand but also in Jakarta, Manila, and Kuala Lumpur immediately began to sell local currencies, setting off a tumble not only in local currencies but also in the stock markets as well.

In the subsequent stage, depreciation expectations created nervousness among local corporate sectors. These local companies scrambled to buy greenbacks to meet repayment of their enormous loans; many of which were unhedged, short-term, and used to finance long-term projects or high-risk schemes including many in the real estate sector.

How did such a loan scheme occur in the first place? Thanks to widespread optimism about the region's future growth and the celebrated label of "East Asian Miracle" (coined by the World Bank), private investors were poised to expand their activities ever since 1994. The high domestic interest rate did not dampen their enthusiasm, largely because foreign loans were obtained easily at a relatively low rate. The label "miracle" also seems to have swayed lenders and the international financial community so that they recklessly made many high-risk loans.

It is unclear, however, which of these two stages contributed most to the currency plunge. What is clear, however, is that early pressures did not come from what some political leaders in the region called "speculators" (i.e., those who attempted to profit from the declining values of a currency). It was only at a later third stage that they may have taken advantage by joining the flux, exacerbating the already slumped rupiah, baht, etc., and further bruising the regional stock market.

After a frustrating two weeks of discussions in October, Indonesia reached agreement with the IMF to come up with a reform package involving some 23 plus 20 billion US dollar. A major step related to the agreement was the decision to liquidate 16 banks, some of which were owned by well-connected businessmen and members of the President's family. After a few days of shake up, including people's rushing to withdraw deposits from the bank, it soon became clear that market confidence had not been restored. Instead, people were in a panic. The rupiah continued to dive and the stock market plunged. Only recently did the IMF recognize that its demand to close insolvent banks backfired and caused the panic.

But it was not until the economic crisis quickly turned into a political crisis that the fear of a collapsed system became real. The IMF seems to have failed to take into account the sudden jump in the political risk premium.

In such a situation, it is not unusual that rumors of all types spread. When President Suharto cancelled his scheduled visits to the ASEAN summit in Kuala Lumpur and to his wife's grave in Solo (only 35 minutes flying time from Jakarta) in early December, many perceived it as a sign of adverse situations. Speculation grew that the country was preparing for a debt moratorium. If true, it would shut off completely the country's access to affordable foreign credits for years, just as it did for large Latin American defaulters in the 1980s. In late December, another rumor spread that Suharto had a stroke and that there was a military coup. In no time the stock market tumbled, and the exchange rate fell to over 5,200 rupiah per US dollar.

Entering 1998, the situation worsened. The way the 1998/99 budget was announced on January 6 did not satisfy the market. The number of laid-off workers continued to increase, adding the already high open unemployment (expected to reach 7 million in this year). The stock market plunged again and the rupiah hit an "insane" level of over Rp11,000 per US dollar. Pandemonium set in when on January 8 and 9 people went on a buying spree to hoard foodstuff. Meanwhile, perceptions were widespread that Suharto had lost his touch. A popular revolt gained strength and public attacks on the government and Suharto's leadership were on the rise. Fearing deeper political turmoil, the armed forces were put on special alert.

Only then did the world begin to react with serious concern. There was a fear that tensions in Jakarta could degenerate into anarchy. The potent mixture of continuing market panic and political uncertainty led an array of heads of state, ranging from Washington to Canberra, to phone Suharto. High ranking US and IMF officials rushed to Jakarta to consult with him and to press for urgent reform. The question is what reform?

Assessing IMF Conditionalities

Since the early 1980s, Indonesia has implemented various economic reforms. The first push was in the financial sector in 1983, followed by a series of trade and investment reforms in the mid-1980s. Bold deregulation in the banking sector, promulgated in 1988, led to a quadruple increase in the number of banks. However, the lack of supervision resulted in a rising number of non-performing loans and subsequently troubled banks.

Aside from the state banks, only a few commercial banks (which are owned by large industrial groups or conglomerates) control the lion share of this oligopolistic market. As in Korea, the structure of the industrial organization in Indonesia--with its high degree of concentration--determines the nature of the financial structure, not vice versa. This spells bad news. The amount of low quality credits is huge, raising the risk factor significantly. In turn, many banks are theoretically insolvent. They remain in operation only through the government's bailout programs of various sorts. Financial institutions with such low quality are the ones that the IMF wanted to liquidate.

After a long debate, it was decided in late October that 16 banks should be closed. While the notion of closing insolvent institutions is legitimate, i.e., free-exit must accompany free-entry, it is questionable in this case whether the closure of an entire bank (forcing blameless workers to be laid-off) is the right thing to do instead of punishing only the owners and the bank's management. In either case, a policy response to minimize the ripple effects of bank closure should have been put in place to avoid panic in the entire financial market.

Next is the interest rate. Realizing that pressures on the rupiah also came from a huge local demand for dollars, the IMF was also of the opinion that interest rates must be raised. The use of liquid assets for the purchase of foreign currency ought to be minimized. Otherwise, the central bank must be prepared to defend the currency with its own reserves. If we use M2 (broad money) as a proxy of monetary assets, the match between such assets and the central bank's foreign reserves (FR) in Indonesia shows that the country is indeed in a vulnerable situation. The ratio of M2 to FR is around 6, the highest among the ASEAN-4 (the higher the ratio, the more vulnerable will be the country to speculative attacks).

The repercussions of this high ratio can be influenced by the way the government responds to the pressures of fund withdrawals. If the central bank takes a firm position not to extend domestic credit to commercial banks, the pressures may lead to widespread bank defaults (the events of 1933 were close to such a scenario). In practice, higher interest rates can also produce similar impacts. There are, of course, other repercussions. Credits, including those for working capital that are badly needed by export-oriented industries, would have been scarcer. Furthermore, a safety net to prevent small-scale businesses from collapsing is harder to provide when interest rate soars.

On the other hand, when domestic credit is extended to commercial banks, funds withdrawals will not necessarily lead to a bank's default but it will be easier to purchase foreign exchange. Pressures on the rupiah will, therefore, mount. In turn, the central bank will be forced to sell its foreign exchange reserves. Obviously, there is a serious dilemma here.

Actually, Indonesian interest rate has been persistently high since the 1988 financial reform. Thus, the country does not seem to fit Mr. Stanley Fischer's allusion that "Asian programmes started after lengthy periods when monetary policy had sought to keep interest rates low.........." (Financial Times, December 17). One of the reasons Indonesia has a high interest rate is because of its open capital account system, i.e., free flow of foreign exchange, that was implemented in the early 1970s, long before the pro-market reform began.

In my opinion, the government should apply a tight liquidity policy in a discretionary manner, exempting the export generating sector and the lower income segment of population (e.g., low income housing).

Turning to the budget, the notion of enforcing a non-expansionary fiscal policy, as recommended by IMF, is not unreasonable. When there is no market confidence, as in the current situation, increased government borrowing should not be encouraged. Instead, expenditures must be curtailed and revenues ought to increase. The question is, how much?

Measured in real terms, assuming a 9% inflation rate, the 1998/99 budget, before the January 15 revision, is actually fairly reasonable. Development expenditures are down by 4 percent, and domestic revenue is up by 13 percent. The problem is in the routine expenditures. Despite the apparent belt tightening, including a freeze in government salary, one third of routine expenditures are allocated for external debt service payment. With the plummeted rupiah, this item increased by 64% in nominal terms or 52% in real terms.

What does this illustrate? The government seems to insist on maintaining its firm position not to default its foreign borrowing and pay the debt service promptly. The source of the crisis is private borrowing, not government debt. But the consequence is also clear, government savings drop dramatically, and are inadequate to finance the development expenditures (which, in real terms are reduced). Hence, increased external borrowing becomes inevitable.

The revised budget, announced after the Suharto-Camdessus meeting, assumes a 20% inflation rate and a zero GDP growth (I predict, however, the realized figures would be a less-than 20% inflation and a positive growth). Even such a scenario would have produced a similar pattern as above.

A more controversial item in the budget is the petroleum subsidy, amounting to Rp10 trillion (US$2.5 billion with the assumed exchange rate). Judging from the president's speech on January 6, I have predicted that the government would in fact consider increasing domestic prices of fuel and electricity, thereby overruling the use of the entire budgeted subsidies. In the revised budget announced on January 15, my prediction was proven right. Suppose, hypothetically, fuel and electricity prices are raised to a level that requires a subsidy of only Rp 4 trillion. Ceteris-paribus, a "surplus" of 1% GDP would be within reach. On the other hand, should the entire subsides be removed, the budget will be in deficit, which, apparently is permitted by the revised budget.

What's Next

The corporate financial situation in Indonesia is still fragile. There seems to be no alternatives to resolving the debt-cum-currency problem other than subscribing to some forms of debt restructuring, which is more desirable than a debt moratorium. Not even strict compliance with the IMF program can help abate the panic caused by continued pressures on the rupiah. But debt restructuring can not be applied to all debtors. Only prudent and healthier corporate entities and those who have a good long relationship with their bankers can, and should, manage to restructure. I know for a fact that some have already done so. A smart finance director would already be at an advanced stage of re-negotiation by this time.

The cutback of monopolies, special treatments, subsidies and tariffs, contained in the 'letter of intent' signed by Suharto and Camdessus, received a subdued reaction: both the rupiah and the stock market slipped. The market seems to be waiting to see the extent to which the proposed policies will actually be implemented in a consistent and more transparent way. The coinciding time of the Standard & Poor's announcement to downgrade 15 Indonesian banks were also not helpful. But far more importantly, the political factor has now come into play.

A recovery for Indonesia is feasible, but a quick one is not possible, especially when the risk of social and political upheaval is on the rise. Yet, it is difficult to predict with certainty what will be the speed of the country's economic recovery. A more definite outlook can probably be made after the presidential elections in March 1998, and after the nature of the new cabinet is known.