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

A presentation in a panel on "Finance in South East Asia" during the conference "Asia at the Crossroad: Challenges and Opportunities", The 1999 Harvard Asia Business Conference, Harvard Graduate School of Business, Boston, MA, February 5-6, 1999.



  • So much has been said about Asian financial crisis that it is difficult to say anything new about the subject. That is not to say that there has been clear understanding about the crisis or that people look at the crisis with a similar notion about what have been the causes of the crisis or what has been the process or how has the crisis unfolded. May be there have been more agreements on the explanation about how the crisis was originated. But it is less so about how to cope with it, whether for each individual economy or for the region as a whole.
  • The facts that many discussions and studies have been conducted, including recent reports prepared by the IMF and the WB have, I am sure, contributed to a better understanding about the problems and related issues. This would help pushing efforts to arrest the crisis and forging further steps to move the most affected economies of Southeast Asia to get back to a sustainable development.
  • Looking at challenges and opportunities implies making assessment about what has been happening so far, as well as viewing the future prospect. This is what I am trying to do this afternoon. But, my presentation will not be comprehensive. Instead, I will present you with some brief picture about the salient points of finance in Southeast Asia through a perspective of the case I am most familiar with, i.e. Indonesia.
  • I would make some brief comment about the crisis itself, and then I would like to discuss the financial sector restructuring programs and their implementations with their implications to shed some light on the future prospects which are both challenges as well as opportunities.


  1. In the unfinished debate about the Asian crisis, there are basically two groups offering explanation about the origin of the crisis. One group holds the contention that the crisis has basically been domestically grown. This view argues that the crisis arises from practices of crony capitalism, with corruption, collusion and nepotism, coupled with rampant monopoly practice, weak fundamental and incorrect government policies. Prof. Krugman could be identified as one of the proponents of this argument. Another group argues that the crisis is coming as the work of contagion effects, the coming of external shocks from a shift in market sentiments, combined with a weak financial sector. The crisis is basically financial panic in the Keynesian tradition, which was explained so well by Prof. Kindleberger in his seminal book. Prof. Sachs represents this group. Yesterday Prof. Perkins called the first argument as the 'structuralist' argument while the second one 'the financial panic' argument.

  2. What has happened in Indonesia, and to a certain degree in other countries in Southeast Asia, is in my opinion, a combination of a contagious process in the currency market (external factor), and the structural weaknesses of the national economies (internal). The crisis then arises from an external shock in the currency market that through a contagion process hitting Southeast Asian economies, which have been embedded with structural weaknesses. Thus, as I observed in Indonesia, the currency shock, which was external in origin, happened in a structurally weak economy, the financial sectors in particular, but also the real sectors, which ultimately turns into a crisis, starting from a financial to economic, and ultimately full fledged crisis.

  3. The Indonesian crisis is the worst in Asia - in terms of the size of currency depreciation, the negative growth rates and social dislocations - because the contagion process has been working strongly, not just in the economy but also in social and political lives. The working of contagion has been facilitated by structural weaknesses in finance and the real sectors of the national economy. The same thing could also be said about social-politics, that the prevalent structural weaknesses have been facilitating contagious process. Thus, from currency shocks it developed into banking or financial and economic crisis and later to a full-fledged crisis, encompassing practically all aspects of peoples' lives.

  4. The claims for the existence of strong economic fundamentals and stable government for sustainable development, popular themes prior to the crisis, have been justifiably questioned. This also implies some notes on the conceptual aspects of the issue. What I would like to point out here is that, certainly there is a wide gap between perceptions and realities. If one tries to compare the implications of the crisis between countries in Southeast Asia, one may find difficulties in explaining why a country is faring better or worse than the other is. I could mention the case of Indonesia here. I would argue that prior to the crisis or at the time IMF help was solicited, the conditions of the Indonesian economy was relatively better than Thailand or Korea. I would also argue that Indonesia was not too late to ask for IMF help. But, why Indonesia came out to be the worst case in the episode?


  1. Started with a rupiah depreciation as part of a contagion process of the financial panic in the region, Bank Indonesia responded the shock by taking some standard steps of foreign exchange management. The policy initiatives and the public reactions to them ultimately resulting in a downward spiral of the national economy and politics. It started with a normal jolt in the currency market when rupiah was hit after the Thai baht, the Philippines peso and Malaysian ringgit were experiencing problem in early July of 1997. A classic exchange rate policy management was applied by the central bank. But, as the pressure on the rupiah was very serious (a part of a contagious process), the steps taken by the monetary authority were not effective, and due to the weak banking structure the economy took the beating badly. Very soon the problem spread to the banking sector itself, when the banking sector experienced a distress. And once the problem involved a loss of confidence in the banking sector, a process of flight to safety was rampant. Depositors and savers moved their funds to other institutions thought to be safer, bigger banks, state banks, foreign banks or foreign currency. Cases of bank runs came out. In short time this process resulted in a crisis, first in the banking sector, but before long it became economic crisis, and finally a full-fledged crisis.

  2. The process from a normal currency jolt to a crisis has been facilitated by a weak financial sector with a weak financial infrastructure in the midst of almost euphoric era for an open economy with an open capital account system. The financial infrastructures are weak as shown in under supervision in banking, lack of transparency, weak legal base and poor legal protection, in a surrounding where good governance, both in the public sector as well as the corporation has not been the trait. The weak domestic financial sector has been confronting a not very strong international finance whereby bank lending to emerging markets was not, in general, adequately supervised.

  3. Moral hazard was strong, both from investors or the supply side as well as banking and corporation or the demand side of the market. Investors: inept perception from investors and lenders that there are implicit guarantee from the host governments and the IMF. It was confirmed by the general use of the term 'IMF bail outs' to refer to the stand-by loans from the Fund. This is strange since it has not been the philosophy not the practice of this institution to bail out an economy. This has gone together with the booming economies (Asian miracle) and relatively slow and low returns in the investors' domestic economies (Japan and Europe). Despite the fact that there have not been any explicit nor implicit government (IMF) guarantees, this had been the general perception of investors and lenders in their dealing with newly emerging economies. The shock came when Russia defaulting in August 1998, which actually showed that the investors' assumption about the existence of the guarantee was not right.

  4. Debtors: similarly the debtors have been in the habit of assuming that the government would not let them to go under (too big to fail). It has also been the perception that these countries adhered to a fixed exchange system. These have been the perception, regardless of the fact that Indonesia practiced a managed floating with creeping depreciation policy for sometimes and that Bank Indonesia kept widening the intervention bands. All of these plus the presence of differential rates of interest resulted in the dangerous practices of high leveraging and careless investments. High exposures in unhedged short term's external debts for financing rupiah earnings of dubious projects by corporations were common.

  5. The financial sector embedded with the characteristics mentioned above is very fragile. A financial panic could arise any time. The shift in market sentiment, which triggered financial panics, originated in Thailand in early July 1997 when there was a fire sale of the baht. This incident spread very rapidly in the region soon after. The weak banking structures as well as the real sectors in Thailand, and especially in Indonesia, had strengthen the contagion process to spread the financial crisis into economic crises. In Indonesia, weaknesses of the social and political structures, in turn, transmitted the economic crisis to a full-fledged crisis.


Assessing the crisis and its implications would involve in analyzing policy responses by the government toward the crisis as well as their public reactions to them. In this regard one should distinguish between the condition before and after the crisis. It may also be instructive to distinguish between the period before and after the coming of the IMF.

  1. The initial policy response to the currency problem was prompt; starting with an immediate step to widen the central bank intervention bands in the foreign exchange market, soon after the Thai baht was floated early in July 1997. However, a completely different reaction came from the market. On previous occasions, every time Bank Indonesia widens the intervention bands - 5 times since 1994 - the rupiah was appreciated. In fact, previously the dollar spot rates followed closely the buying rates of Bank Indonesia. But, this time, the rupiah depreciated after the bands were widen. Faced with persistent pressure on the rupiah, the government intervened in the foreign exchange market, first by selling dollar forward, and later, in the spot market. When these efforts could not strengthen the rupiah, Bank Indonesia discarded the managed floating exchange system, and floated the rupiah freely in mid August 1997. These were done with the support of monetary tightening through drastic increases in interest rates, administrative intervention, as well as fiscal tightening. But, partly due to the monetary and fiscal tightening, the weak banking sector started to suffer a distress. In fact, a sizeable bank (Bank Dannamon) had experienced a run in late August 1997. In early September 1997 the government launched a broad economic policy initiative, which encompassed not just monetary and fiscal measures, but also deregulation steps in the real sectors This was a precursor of an IMF-supported program.

  2. The IMF-supported program was introduced through a letter of intent with a Memorandum on Economic and Financial Policies (MEFP), submitted to the Fund on October 31, 1997. The program was comprised of a package of policies for economic reform in the real sector and financial restructuring to be supported with prudent monetary and fiscal policy. The monetary and fiscal measures were comprised of standard programs of macroeconomics management to cope with exchange rates and other monetary variable issues together with fiscal ramifications. In essence, the program was built around three areas, namely:
    • a strong macroeconomics framework designed to achieve an orderly adjustment in the external current account, incorporating substantial fiscal adjustments as well as 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 which also improve governance.

  3. 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, together with the Monetary Authority of Singapore and the Bank of Japan, were welcomed by the (external) market and resulted in strengthening the rupiah and temporarily stabilized it at a stronger rate, from 3900 rupiah to 3200 rupiah to the dollar. However, the domestic reaction on the closing of banks was the reverse of what was expected. It was ironic that a step, which was designed to boost the confidence to the banking sector instead resulted in the collapse of the confidence. The banking sector suffered from a 'flight to safety and to quality' since then. Many banks lost their deposit base, the inter bank money market suffered from compartmentalization, and since January 1998, letters of credit issued by Indonesian banks were not accepted abroad. The problems of confidence in the national economy basically involved three areas: the rupiah exchange rate which was weakening dramatically against the dollar, the banking sector which was losing its deposit base as well as creditors, and the business sector that was unable to repay foreign debts.

  4. After some flip-flop implementation of the IMF-supported program with a record four Letters of Intent in seven months, coupled with social unrest spearheaded by continuous students' demonstrations, the confidence problem shifted from not just an economic problem but to a problem of national leadership as well. When Suharto was still in power the overriding question was his sincerity in implementing the difficult reform program. Actually, the market, the foreign market, lauded the closing of the 16 insolvent banks in particular. But domestically the closing of banks was badly received. It even caused further loss of confidence in the banking system. However, when some political intervention by the government was suspected on the execution of bank closures, and the Suharto family's reaction to bank closures by suing the Governor of the Central Bank and the Minister of Finance to court, the foreign market started to react negatively also. This had basically transformed the banking sector from a state of distress into a crisis when market confidence was almost completely lost.

  5. The negative reaction to the implementation of the reform program was more pronounced when a reversal was announced of some decisions to postpone big government projects. At about the same time there was a reappearance of monopoly practices and some other inconsistencies in the implementation of the program for restructuring the real sector. These had been followed with rumors of Suharto shaky health, the dismissal of 4 managing directors of the central bank and others. As a result, the rupiah downward slide was not just difficult to stop, but the economic crisis was rapidly shifting into a total crisis in a downward spiraling process. President Suharto had to pay dearly for not addressing the problem head-on by resigning in humiliation on May 21, 1998.

  6. In eight months after his unexpected elevation as the new President, Dr. Habibie has been surprising many people as a national leader who has been trying very hard to do and say things that are politically correct. He has been making positive steps in human rights and restoring the path toward democratic government by the promise to hold election in June 1999. He has also been scoring some points in strengthening and stabilizing the rupiah. But, with news about student demonstrations, social unrest, ethnic Chinese's problems and safety condition, the market is still taking a 'wait and see' attitude


An accurate assessment about the crisis would be able to guide us to make points about the future prospect. This is in essence identifying challenges and opportunities of our topic of discussion, the finance of Southeast Asia, or to be more specific, the finance of Indonesia. I would like to list some points from the Indonesian experience, which I would argue, have some bearing on the design of the 'new international financial architecture'. I present these points as some lessons to be learned from the financial crisis:

  1. Some lessons from financial liberalization policies in Indonesia, which was mostly adopted in the late eighties and nineties, are in order. The Indonesian experience underlines the argument that banking liberalization has to be done in co-ordination with the improvement of the financial infrastructure, including strict prudential measures and supervision, adequate disclosure, governance, legal protection and market discipline. Proper sequencing is very good, but different original condition may require different sequence. Furthermore, it is impossible to move backward or to retract once a path of liberalization is adopted. The real world of a national economy is more complex than what the sequencing theory suggested. I guess, what have been proposed in the new international financial infrastructure is very good. But, we have to acknowledge that people only discussed and maybe agreed about them very recently. A case in point, the proposal on financial liberalization that has to be done prudently, in accordance with the readiness of the financial infrastructure, is a new thing. Those countries which liberalized already was not aware of or being reminded about these. Similarly has been with capital account liberalization, and so has the suggestion about the role of the private sector. All of them are new awareness. Indonesia has not been 'lucky' in this respect. Indonesian experiences in liberalization may look like putting things on their heads. We did many of these steps early, and now, with the benefit of hindsight, they have not been done properly. The problem is, can Indonesia retract and facing the danger of adverse market reactions?

  2. Lessons from the past crises are still valid here, namely that the sooner the better and the problems are usually worse than expected. Some make a distinction between a crisis and a panic (see Philippe F.Dehaise "Asia in Crisis: The Implosion of the Banking and Finance Systems"). A financial panic seems to be a part of the Asian crisis. But, the note I would like to note here is simply that the financial panic that we observed had been part of the contagion process. And when we are confronting a problem of contagion like rapid currency depreciation, the sooner we make effort to cope with it, the better. An internal study by Bank Indonesia in 1996 showed the number of problem banks and cost for their restructuring that were both much smaller than the estimated magnitudes in the IMF supported program of October 1997. Basically, the sooner the problems are identified or recognized and the sooner they are properly addressed, the smaller the cost involved and thus, the better the chances for success. In many things, including the new awareness mentioned above, it was too late, even if not too little.

  3. The weaknesses of the banking structure have been the major culprit in the contagious process of the financial and economic crises. So, I would argue that the Indonesian experience supports the contention that banking soundness is a requisite for sustainable monetary policy. It is even plausible to suggest that the linchpin of the crisis is the weak banking system, which has constrained the monetary authority in conducting monetary policy and banking supervision as well as facilitating payment system. I think the inclusion of banking soundness, as an explicit objective of monetary policy, as argued by Guitian, should be seriously considered. However, I cannot help but noting that, even though there has been an increasing awareness of the close link between banking soundness and macro-economic policy, partly to the socialization campaign by the IMF and others, it has not been adequate to prepare monetary authorities and market players in developing countries to cope with the crisis. And this lack of preparation has resulted in devastating impacts, especially in Thailand, South Korea and Indonesia. The sooner must have been the better.

  4. In an effort to create a sound banking system by implementing a program that combine banking restructuring and monetary management, we have to be very cautious about the fact that we are working with different variables in terms of their time frame. Monetary policy deals with variables, which have short time lag, even though it has long term implications. To adopt a tight or lose monetary policy is a short run issue. Furthermore, it deals with macro economic variables. Banking restructuring is, however, a long-term problem. It deals with problems of efficiency, management, supervision, regulation, law enforcement, banking ethics, etc., which are long terms and micro-economic issues. I do not want to imply that because they are long term problems a country has more time to address them. The point I would like to raise is that we have to be extra careful in designing and implementing a program that combines monetary policy and banking reform. They are very closely related, and yet they are problems of different nature.

  5. The Indonesian experience also teaches us that, when public expectation is fragile, the closure of insolvent banks, a must for creating a sound banking system, could have an adverse result. A step, which was originally intended to regain public confidence, resulted in a further loss of it. The issue of confidence is not just important for the soundness of the banking system, but also for the working of the national payment system. Some would argue that closing or freezing financial institution should also take into consideration its impact on the payment system. (David Cole argues that one should make some distinction between the closing of the 16 Indonesian banks from the freezing of finance companies in Thailand and the closing of a number of merchant banks in Korea). Liquidation of bad banks has to be done in a banking sector restructuring program. The issue is how and when should you do it. Lesson to be learned from the Indonesian experience with bank closures is that it should be done when the economy is not in distress, when public expectation is not fragile. This is, of course, easier said than done. However, it remains true that, the sooner the better, and the later the costlier. Indonesian experience in bank closure also told us that executing this policy has to be very well prepared, including preconditioning for the public.

Finally, I would like to close with a note that at present, at least for Indonesia; the first priority is still on how to end the crisis or how to make a turn around. For Indonesia, this means dealing squarely with the food problems, social unrest and politics. Another words, the issues are outside economics and finance. The main problem lies in the capability of the national leadership to establish and maintain political and social stability to facilitate the national efforts for ending the crisis and to turn around the slide down for economic recovery. Indeed, a democratic national election as promised by the government is the key. But, we still have to wait whether, if the election is materialized, the election could really produce a national leadership capable of dealing with these daunting problems and challenges.

Cambridge, February 6, 1999.

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