by J. Soedradjad Djiwandono (*)

An address at a seminar " Capital Flows in Crisis" sponsored by the World Bank and the Reinventing Bretton Woods Committee, Washington, D.C. October 27-28, 1998.


It is an honor and privilege for me to address such a distinguish group on a topic which has become very popular in most meetings; capital flows in crisis and the international financial architecture. With respect to the crisis, we have observed that, in a relatively short period the problem has been spreading from a currency shock in Southeast Asia to become economic crisis, influencing most economies the world over. And especially for those countries suffering the most, the crisis is no longer limited to economic, but practically most aspects of peoples' lives. The contagion has been working not just geographically, from one country to another, but also from one aspect of peoples' live to another.

In terms of the origin of crisis, it has been argued by many that a high exposure of the Southeast Asia's economies to capital flows has been one of the major problems. Thus, issues of capital flows in crisis become very important.

I would like to discuss the issues of capital flows in crisis, using the Indonesian experience; by looking at them as a part of the process of how does economic crisis unfold. This, in effect, means to look at problems related to capital inflows and outflows, policy responses of the monetary authorities and market reactions facing with their implications. Based from these observations assessments on issues related to the international financial architecture will be presented.


It has been widely accepted that capital flows have been contributing to the outstanding performances of many emerging countries' economy. This means that they are basically good. One of the implications is for the developing countries to pursue policies that would facilitate capital movements free to move. Both the surge of capital inflows to the emerging markets in the 1990's and the liberalization steps taken by these countries have been widely recognized and documented. And so have the economic, and to a certain degree social, performances which come along with or following the capital flows and steps to facilitate them.

But, the Asian crisis, which is still going on right now, has also been demonstrating very clearly, the risks associated with free capital flows. Capital inflows, which had been benefiting the emerging countries suddenly, show their downside. Capital inflows have been benefiting the emerging countries in their efforts to achieve faster economic growth, improved standards of living and developing financial markets. But, when these countries experiencing economic crisis, the reversal flows have been at least exacerbating if not causing the crises themselves.

Capital inflows also expose the receiving countries to external disturbances, which could have destabilizing effect. In the midst of crisis, especially for those countries suffering from it, the concern is, understandably, on the outflows of capital. Sudden outflows of capital which were hitting Thailand and Indonesia in the beginning of the Asian crisis, but was later becoming a common phenomenon in Southeast Asia, caused economic problems through their effect on the availability of funds as well as pressures on the currency.

However, experiences in these emerging countries show that inflows could also raise some problems for monetary management in the receiving countries, especially in terms of their impacts on inflation, exchange rate stability and export competitiveness. In fact, in the period prior to the crisis, among central bankers in the emerging countries in Asia, one of the popular topic of discussions in most of their gatherings was on how to deal with surges of short terms capital inflows. The surge of capital inflows, the major part of them was short terms, was a common phenomenon in these countries then. At that time proposals to constrain capital movements like implementing the "Tobin tax" or any step to 'sanding the wheel' was frequently mentioned as a proper policy to adopt. Interestingly, the mentioning of capital control was almost unheard of then. This is in contrast to the recent development, especially since Paul Krugman's argument for capital control and the subsequent capital control policy adopted by Malaysia recently.1

But, this is one of the many surprises about the crisis; before concrete steps could be adopted to address the adverse effects of capital inflows, the pressing issues shifted to problems of capital outflows. As we have observed recently, discussions on how to manage capital flows have been arousing wider interest, including all of us here participating in the seminar.

Before I come to the issues of capital flows, allow me to discuss briefly about the crisis itself. I think, after so many discussions about the crises, at least there seems to emerge some pattern of explanations on the issue of the Asian crisis, as to what seems to be their causes. However, the 'consensus' seems to be less on what lessons could be derived from the crisis, and much less on how to get out from the crisis. Another consensus seems to be developing on areas of what to do in the medium to long run, for countries suffering from the crisis, how to reduce the contagion and how to avoid it in the future. These are issues, which we are now looking at, the well-known international financial architecture.

In the midst of competing theories about the causes of the crisis, whether they are domestically grown - either from practices of 'crony capitalism', wrong policies or weak fundamentals - or otherwise - coming from a shift in market sentiments and the work of contagion, I observed that a combination of these factors has been what actually developing. At least, I can say with more confidence that this has been the way the crisis develops in Indonesian.

Analytically, the Indonesian crisis could be explained as originating from changes in market sentiment in the region that led to an external shock in the currency market which subsequently caused contagion in the region. The rapid downgrading process of the region's sovereign credit ratings demonstrated the shift in market sentiment. In the media, the term 'Asian miracle' was disappearing, and replaced by 'crisis', 'chaos' and 'meltdown'. But, the most telling was the Institute of International Finance's report, which showed a dramatic change of capital flows. It was reported that for Thailand, Malaysia, Indonesia, the Philippines, and South Korea, the shift was from inflows of $93 billion in 1996 to outflows of $12 billion in 1997, or a change of capital flows of $105 billion in a single year. Indonesia suffered a reversal of capital flows of $22 billion in a year, from inflows of $10 billion to outflows of $12 billion.

Confronted with the contagion effects, the Indonesian economy that had been suffering from inefficiency in the real sector, a high cost economy, suffering from crony capitalism, and a weak financial system - banking in particular - could not cope with the shock. The domino effect of the weakening rupiah adversely affected the financial sectors, and on to the real sectors of the national economy. Thus, a combination of severe external shocks, triggered by changes in market sentiments, and financial cum real sector structural weaknesses had caused a contagious process that ultimately severely damaging the whole economy. But, it did not stop there, since, after sometime the problems went beyond economics. Here, the spread from economic crisis to a social and political crisis was also through a contagious process, facilitated by inherent weaknesses in the Indonesia's social and political systems.

It may be instructive to analyze whether the origin of Asian crisis is domestic or external, whether we believe in 'first generation' or 'second generation' of how do crises develop.2
But I found that both approaches have their weaknesses when they are confronted with observations. I felt that, at least in the case of Indonesia, a combination between the two has been at work. Furthermore, both sides have argued that in the process both external and domestic factors have been contributing to the crisis. Both have argued that the high dependence of corporations in these countries on short term foreign capital inflows together with weak and under supervised banking sector have been instrumental in causing the crisis

Capital flows have been closely related with the Asian crisis. As reported in the IMF Survey on International Capital Markets, aside from distinctive feature there are similarities between Asian crisis and the previous crises, the debt crisis in the 1980's and the Mexican crisis in 1994/95.3 The similarities are, that in the periods leading up to each of the crises were characterized by surges in private capital inflows and the emergence of large unhedged exposures of domestic borrowers and the existence of weak regulatory regimes. Here, the arguments of 'herd instinct' of the corporate sector and the role of 'confidence' in investment decision from Keynes are well known. They seem to be valid both for the domestic borrowers as well as the foreign lenders or investors. The herd instinct works both on the capital inflows, in the period prior to the crisis, as well as the capital outflows, during the crisis.

The Asian crisis demonstrates that the herd instinct has been dictating the market players, both domestic as well as foreign creditors, and borrowers. Some argued that investors had been putting their money in the emerging economies because of their belief that the host government would not allow any bank to collapse. The usual moral hazard argument. These people believe that host governments based their policy on the 'too big to fail' concept. But, when the expectation is not materialized, meaning that these governments did fail banks from whatever reasons, they were shocked. I found this does not make much sense. May be these people have to accept that their assumption - about the presence of moral hazard, i.e. that host governments or IMF will come to bail out banks - was wrong, and not blaming others. May be the conventional wisdom that the market or the private sector knows better is not always valid. Also the perception that bankers know better (than corporate companies) or that foreign players know better (than indigenous market players) have not been right in the first place.

In Indonesia, at least, the fact was that with a strong performance in the Indonesian economy and the weakening of the economies in the debtor countries, Japan and Europe in particular, it was attractive for investors from these countries to invest in Indonesia and other emerging countries. For the Indonesian corporates, the high rates of interest at home, which correctly reflecting market condition had made them, choose to borrow abroad more, instead of borrowing domestically. The assumption of the existence of guarantee by the lenders, despite the fact that there was no explicit or implicit guarantee in the system, made them lend their money imprudently. Furthermore, the assumption on the government commitment to a 'fixed exchange rate policy' by the borrowers, despite the practice of creeping depreciation and continuous widening of the intervention bands, made the corporate sector eagerly borrowing abroad unhedged. The bigger the gap between the perception and the reality, the bigger the gap between domestic and international rates of interest, the bigger is the foreign exposures of the private sector. When the government floated the rupiah, all the expectation was ruined and everybody was in trouble. The corporate sector debts are part of the major problems facing Indonesia.

Michael Pomerleano of the World Bank in his article in "Viewpoint" shows the corporate roots of the financial crisis in East Asia. A combination of high-debt, high risk model of economic development and lack of financial and institutional discipline in an environment without an adequate prudential framework results in the mix of currency, corporate and banking crisis in East Asia.4

(*) Professor of Economics, the University of Indonesia and a Visiting Scholar at the Harvard Institute for International Development (HIID).

1. See Paul Krugman, "Saving Asia:It's Time to Get Radical", Fortune Investor, September 7,1998.
2. See Michael Dooley, Origin of the Crisis in Asia, a paper presented at the conference 'Asia: An Analysis of the Financial Crisis' cosponsored by the Federal Reserve Bank of Chicago and the International Monetary Fund, October 8-10, 1998.
3. Charles Adams et al, International Capital Markets: Development, Prospects and Key policy Issues, (Washington DC: IMF), September 1998.
4. See Michael Pomerleano, 'Corporate Finance Lessons from the East Asian Crisis', Viewpoint, September, 1998.

[index] [Next]