POLICY RESPONSES FACING FINANCIAL CRISIS

Oleh : J. Soedradjad Djiwandono
Gurubesar tetap Ilmu Ekonomi, Universitas Indonesia


POLICY RESPONSES FACING FINANCIAL CRISIS:
Indonesia's Macroeconomic Policy in Fall 1997

Pointers for a panel "Macroeconomic Policy in Fall 1997", NBER Project on Exchange Rate Crises in Emerging Market Countries, Indonesia, Cambridge, September 15, 2000.

By
J. Soedradjad Djiwandono

INTRODUCTION

I would present some salient points of the Indonesian government's policy responses in the early part of the crisis and assessments on how these policies were formulated and implemented.

I would attempt to answer several questions posted by the organizer of the conference for this session, Macroeconomic Policy in Fall 1997. They include; was the initial macroeconomic policy response appropriate? Was the rupiah initially overvalued? After the Thai crisis of July 1997, Indonesia widened its currency bands but still suffered a severe depreciation. Why? What does this say about the new conventional wisdom that narrow bands are unsustainable? What was the role of IMF? Dit it in any sense cause or exarcebate the crisis? Was the IMF program poorly designed?

EARLY POLICY RESPONSES

  1. Prior to the coming of the IMF with a stand-by arrangement (SBA), the policy responses of the Indonesian government in its effort to cope with the financial shock started in early July 1997, comprised of exchange rates policy and its supports to stabilize rupiah, and a more comprehensive set of policies afterwards.
  2. Facing financial pressures in the currency market, Bank Indonensia, the central bank, dicided to widen the currency bands, from 8% to 12 % on July 11 1997. This step was taken with a view to the exchange rate management that had been implemented since the beginning of the 1990's, namely a managed floating system with creeping annual depreciation of the rupiah and interventioan bands. Bank Indonesia had been exercising steps of widening the bands, 6 times altogether within a period from January 1994 to September 1996. The bands were plus and minus 0.25% around the mid rate ( a spread of 0.5% ) prior to January 1994. The last step for widening the bands prior to July 1997 was done in September 1996, when the spread was raised from 4% to 8%.

BANK INDONESIA INTERVENTION SPREAD
Date of Change Before (Rupiah) Per cent After (Rupiah) Per cent
16 Sep 1992 6 0.25 10 0.50
3 Jan 1994 10 0.50 20 1.00
5 Sep 1994 20 1.00 30 1.50
30 Jun 1994 30 1.50 44 2.00
29 Dec 1995 44 2.00 66 3.00
13 Jun 1996 66 3.00 118 5.00
11 Sep 1996 118 5.00 192 8.00
11 Jul 1997 192 8.00 304 12.00

  1. The policy was lauded by many, including the IMF, as a good step to face the financial crisis during the meeting of the Consultative Group on Indonesia (CGI) in Tokyo, mid July 1997. Unfortunately, it was only for a very short time. Rupiah was under heavy pressure almost immediately after the widening of the bands. Why? With the benefits of hindsight, one could argue that the problems that Indonesia faced in July 1997 and after were more serious that obviously could not be absorbed by the current device of exchange rate mechanism. There were two occasions before that support the argument for the effectiveness of the mechanism in stabilizing rupiah. Rupiah was under pressure in January 1995, as an indirect effect of the Mexican crisis. However, it was so happened that BI widened the bands in late December 1994. This move combined with market intervention of USD 700 million in the spot market stabilized rupiah winthin a couple of days. In July 1996, after some social unrest started with the burning of the Indonesia National Party's Headquarter, rupiah was also under pressure. But, the combination of widening the bands (June 1996) and BI intervention could do the job to stabilize the rupiah. Thus, the argument for implementing intervention bands. But, how wide should the bands be?
  2. The market reaction to BI policy of widening the bands in July 1997 was different from the two previous occasions. I could tell the different in the market reaction from the development of the spot rates of the US$. In the past, the spot rates of US$ had been closed to the buying rates of BI, and everytime a step of widening the bands was taken, rupiah was appreciated. That seems to indicate that the market accept BI policy in stabilizing rupiah. But, in July 1997, almost immediately after the widening of the bands, the US$ spot rate went up, and rupiah was depreciated heavily. Why? I guess because the foreign market players, who acted as leaders in the Indonesian currency markets, didn't have any confidence in the ability of BI to stabilize rupiah. Since the financial pressures were regional, following a contagious process, the foreign players already made their mind that the problem was regional and their response was to sell local assets or buy US$. On the other hand, the domestic players in the beginning still followed the old practice, taking long position on rupiah, but after learning that they made mistakes, they followed their foreign colleagues, by selling rupiah or buying US$. This shock triggered a wave of US$ buying by Indonesians as a part of the flight to safety process. Rupiah was under heavy pressures, and the widening bands didn't work the way it did in the previous two occasions.
  3. In the managed floating tradition, when the spot rate of the US$ crossed BI selling rate, BI intervened the market. This was done together with steps to reduce the rupiah liquidity. But, the pressures on rupiah continued. And the government decided to float the rupiah freely in August 14. Again, many applauded the step. In fact, by mid August Indonesia was the only country not floating its currency yet. Bath was floated on July 2, peso July 11, and ringgit July 14.
  4. With a view to Indonesia's experience, I have to accept the new comventional wisdom that narrow bands are unsustainable. In dealing with contagion and the market practices that exchange rate determination seems to be more determined by market perception than economic fundamentals, narrow bands are definitely not sustainable. For one thing, market players do not seem to accept the difference between a fixed or pegged exchange system and a managed floating or "the crawling band of John Williamson" (1996). In the market players's perception all these systems are basically fixed exhange system. And they know that monetary authorities could not stand against the market wish to defend the value of their respective currencies in a fixed system. They made attempts to speculate, even against Hongkong dollar and Singapore dollar, even though they didn't make much dent. The Asian crisis attested that to the eyes of market players, economic fundamentals as well as exchange rate regimes in several countries in Southeast Asia are the same, and thus the contagion of the financial crisis.
  5. Narrow bands are not sustainable as market players would not distinguish them from fixed exchange system. Fixed exchange system is not sustainable because monetary authorities cannot withstand contagious financial disturbances. What about fixed exchange system with monetary board? As long as it is supported by proper infrastructures and substantial amount of international reserves, it has a chance of being sustainability as Hong Kong and some other countries show. Martin Feldstein's self guide for emerging markets (1999)
  6. Was rupiah initially overvalued? I think so. But, I would argue that most people who argued that rupiah was overvalued then, didn't prepare to see a depreciation of more than 70 per cent in less than a year. Rupiah was overvalued. However, I think it was in the order of a couple of per cent. The system of managed floating applied from mid 1980's was basically a system with intentional depreciation on stages, to accommodate a room for supporting export competitiveness. The depreciation was less than what should be if purchasing power parity was implemented.
  7. I was caught in the middle between the World Bank staffs, who were generally in favor of seeing a faster depreciation of rupiah for observing an overvalued rupiah and the IMF staffs who were in favor of rupiah appreciation for fighting inflationary pressures from rapid economic activities and large capital inflows since early 1990's.
  8. After the floating of rupiah, US$ intervention and liquidity tightening that went with it, the banking sector started to suffer distress. The problems facing the government started to spread to the banking sector and the real sectors.The policy introduced in early September 1997 was a more comprehensive policy, encompassing monetary, fiscal as well as liberalization steps in the real sector. Among Bank Indonesia staffs, I refer to the policy of early September 1997 as a 'self imposed IMF program'.

IMF- SUPPORTED PROGRAMS

  1. Since the problems continued, and both the financial institutiuons and economic management suffered from loss of confidence in the market, the government asked for help from the IMF in early October 1997, in the hope to restore confidence for stabilization and economic recovery. The first letter of intent (LOI) to the IMF was sent to Washington in October 31, 1997, and the Board approved it November 5 1997.
  2. Several notes on IMF-supported program: With the benefit of hindsights, most would agree that the two most important factors, either causing or exarcebating the crisis, are weaknesses in the banking sector and the unsustainable corporate debts in foreign exchange. There were controversial issues in each of the policy treatment in the face of each problem. On banking restructurization, there were several problems to be mentioned. One of the major issues was whether closing 16 banks is too many or too few ? Morris Goldstein (1998) argued strongly that more banks should be closed ). Could different steps in bank closure produce better results? What about the role of deposit insurance or blanket guarantee? Could freezing banks the way Thailand did, be a better alternative? Issues of bank closures, bank runs and BI liquidity supports

SOME NOTES

  1. Was the initial policy response appropriate? Despite over generalization by market players that saw economic conditions of countries suffering from the Asian crisis were similar, further scrutiny would show that they were not identical. Later studies, like those done by Kaminsky (1999), Goldstein, Kaminsky and Reinhart (2000), Berg (1999), and Hussain (1999), showed that their arguments for designing early warning system or explaining the origin if the crisis did not fit Indonesia's case, due to its difference from the other crisis countries. But, if Indonesia had less convincing early signals for financial crisis, and if the early policy response was all right, what would explain Indonesia turn to become the worst case of the Asian crisis? What went wrong?
  2. What has been the IMF role? Did IMF play the role of a cause of the crisis or did it exarcebate the crisis? Issues related to IMF roles in bank closures, blanket guarantee schemme and policy towards corporate debts.
  3. Indonesia's condition was not worse than both Korea and Thailand at the time of asking for the IMF stand-by arrangements. Indonesia's initial policy responses were appropriate, how come Indonesia become the worst case in the Asian crisis?

REFERENCES

  • Berg, Andrew (1999), The Asia Crisis: Causes, Policy Responses, and Outcomes, IMF Working Paper, WP/99/138 ,Washington DC: International Monetary Fund
  • Claessens, Stijn (1998), Systemic Bank and Corporate Restructuring : Experiences and Lessons for East Asia, Washington, DC: The World Bank Group
  • Claessens, Stijn et al (1999), Financial Restructuring in East Asia: Halfway There?, Financial Sector Discussion Paper no 3, Washington DC: The World Bank Group.
  • Feldstein, Martin (1999), A Self - Help Guide for Emerging Markets, Foreign Affairs, New York: Council on Foreign Relations, Inc. pp. 93-109.
  • Goldstein, Morris (1996), The Asian Financial Crisis:Causes,Cures and Systemic Implications, Washington DC: Institute for International Economics.
  • Goldstein, Morris, Graciela L.Kaminsky, Carmen M. Reinhart (2000), Assessing Financial Vulnerability :An Early Warning System for Emerging Markets, Washington,DC., : Institute for International Economics.
  • Hussain, Qaizar and Clas Wihlborg (1999), Corporate Insolvency Procedures and Bank Behavior: A Study of Selected Asian Economies, IMF Working Paper, WP/99/135, Washington DC.,: International Monetary Fund.
  • IMF Staff (2000), Recovery from the Asian Crisis and the Role of the IMF, Issues Brief for 2000, (http://www.imf.org/external/np/exr/ib/2000/062300.html).
  • Kaminsky, Graciela L. (1999), Currency Banking Crises: The Early Warning of Distress, IMF Working Paper, WP/99/178, Washington DC.,: International Monetary Fund.
  • Lane, Timothy et al (1999), IMF-Supported Programs in Indonesia, Korea and Thailand: Apreliminary Assessment, Washington DC.,: International Monetary Fund.
  • Lindgren, Carl-Johan et al (1999), Financial sector Crisis and Restructuring : Lessons from Asia, Washington DC.,: International Monetary Fund.