MONETARY POLICY AND THE BANKING SYSTEM IN INDONESIA:
SOME LESSONS

by J. Soedradjad Djiwandono @


The India-ASEAN Eminent Persons Lecture, New Delhi, September 12, 1998

-oOo-

INTRODUCTION

It is a great honor to be here at the invitation of the Research and Information System for the Non-Aligned and Other Developing Countries (RIS) to deliver the fourth lecture in the India-ASEAN Eminent Persons Lecture Series Program. I would like to convey my deep appreciation to the RIS, especially to Dr. Panchamukhi, for giving me the privilege of taking part in enhancing the friendship between India and Asean through my participation in this program. I would like to do so by sharing with you, my assessments of what has been developing in Asia lately, the financial and economic crisis, with reference to the Indonesian experience.

I will start my discussion by offering an assessment of how the crisis has been developing in Indonesia in the Asean context, both analytically as well as chronologically. By looking carefully at the process of how the crisis was unfolding, the policy responses by the government and market reactions we could get a clearer picture as to what the really problems facing these economies have been. The discussions on the policy aspects will cover both the monetary as well as the banking aspects. It is hoped that from this analysis, some lessons could be learned for future macroeconomics management and for better cooperation in economic policies among countries in our two regions as well as in a wider context.


@ Professor of Economics, the University of Indonesia and former Governor of Bank Indonesia, the Central Bank of Indonesia.

FROM CURRENCY SHOCK TO ECONOMIC CRISIS

It has been said by many that the Asian crisis stands out as one of the major crisis of the century, especially for those countries which are experiencing the turmoil. The impact of the crisis has been so devastating that, even pessimists acknowledge that it has been worse than their expectations. Indonesia, together with Thailand and South Korea, have been suffering more than others. And it is certainly indisputable to argue that, among the three, the Indonesian case is the worst. In terms of the decline in economic growth, depreciation of the currency, social dislocation and other problems, Indonesia has undoubtedly suffered the most.

The World Bank described the very dramatic Indonesian crisis, in a recent document for the CGI ( Consultative Group on Indonesia )1 meeting in Paris, as follows :

  • the collapse of the exchange rate from 2500 to levels as low as 15000 has contributed to one of the largest real depreciation in the post- world war two era;
  • · the turnaround in growth of 22 percentage points (from positive 7.8 percent in 1996/97 to possibly negative 10-15 percent for 1998/99) dwarfs anything experienced in the OECD countries since the Great Depression;
  • the $22 billion reversal of private capital flows, from inflows of $10 billion in 1996/97 to outflows of $12 billion in 1997/98 is nearly as large as total net capital flows in the entire decade to 1985-95;
  • the financial and economic crisis has been accompanied by natural disaster. The drought occasioned by El Nino reduced rice harvests and agricultural production generally and severe localized droughts contributed to uncontrollable forest fires;
  • the price of Indonesia's key export, oil, has fallen to $13 a barrel, its lowest level in real terms in 30 years;
  • enormous political changes are taking place.2

It has been my conviction that the Indonesian crisis originated from an ordinary currency problem, when the rupiah suffered from sudden pressure in July of last year, after the weakening and the floating of the Thai baht in early July 1997. However, after a process of policy responses by the government and reaction from the market, the problems spread rapidly and deeply to effect all sectors of the national economy, before finally impacting politics.3

The process of how the crisis developed in Indonesia could be described as follow :

  • It started with market pressure on the rupiah as part of the contagion effects from imbalances in the currency markets in the region. Facing such pressure in the currency market, the government, based on its exchange rate management policy of a managed float with creeping depreciation, which relied on the mechanism of intervention bands which had been adjusted continuously since 1994, took the decision to further widen the bands, from 8% to 12% on July 11, 1997; the day the Philippine peso was floated.
  • The market reaction to Bank Indonesia's move was in contrast to its past pattern. Previously, every time the BI intervention bands were widened (5 times from 1994 to 1997) an appreciation of rupiah usually followed. However, this time the rupiah rapidly depreciated instead. When the spot rate crossed the BI selling rate, some intervention in the currency market was exercised. This intervention began with forward sales of dollars in the beginning, and later progressed to spot sales. The pressure on the rupiah was not abating, however, despite market intervention by the central bank.
  • Bank Indonesia floated the rupiah on August 14, 1997. Intervention in both the forward and spot markets were continued. To support the currency intervention, monetary tightening, through monetary and fiscal means, was conducted.
  • After Bank Indonesia intervened in the market several times and exercised monetary tightening, the problems started to spread to include the banking sector. The Indonesian banking industry started to experience distress. And, as the problems continued, confidence in the banking sector started to decline. The banking sector experienced the familiar process of flight to quality and flight to safety. A crisis of confidence started to appear, through the weakening of the rupiah, tiering of the interbank money market, and a loss of confidence from bank depositors and creditors.
  • After some time, the real sector started to feel the impact since banks reduced their lending and lending rates rose dramatically. The banking sector experienced a crisis, especially after the closing of the 16 insolvent banks. Thus, starting from currency shocks and the rupiah crisis, through to banking distress and a banking crisis, the final result was a total economic crisis. 4
  • The impacts of the economic crisis on politics and society almost became self fulfilling. When economic recession became a reality, social unrest broke out everywhere and public confidence on the government and the national leadership was gone.

The chronology of the crisis is as follow:

  1. The rupiah was under heavy pressure, following the floating of the baht (July 2), and the peso (July 11).
  2. Bank Indonesia's (BI) intervention bands were widened, from 8% to 12%, following similar steps taken in previous years (five times since 1994).
  3. The rupiah was freely floated, thus abolishing BI's intervention bands on August 14.
  4. BI's intervention in the currency market, started with forward sales of US dollars to sales at the spot markets. This move was complemented with steps to tighten the monetary position: by stopping sales of money market bank certificates, raising BI certificates' rates (SBI rates of interest); requesting state enterprises to move their bank deposits to be placed in SBIs, and the temporary postponement of government expenditures.
  5. The government took some macro-economic management steps, a precursor of the IMF supported program, on September 3, 1997.
  6. The government made the decision to request IMF assistance on October 8, 1997.
  7. The process of negotiations began for an IMF supported program, from precautionary to stand by arrangements. The first Letter of Intent with the IMF, encompassing programs for economic and financial restructuring which were complemented with prudent monetary and fiscal programs, was signed on October 31, 1997. The size of the program was a front line of defence of $23 billion (actually this should be reduced by $5 billion which were Indonesia's own reserves which had been set aside for this purpose) plus $20 billion of second line facility.
  8. The liquidation of 16 banks and the first drawing of the IMF loan of $3 billion on November 1 1997, which was followed by political repercussions over the next two months.
  9. The new state budget was announced on January 6 1998, immediately followed by negative market reactions.
  10. The government's second Letter of Intent with the IMF was signed on January 15, 1998, by President Suharto, followed by negative market reactions to the nomination of Dr. Habibie for the vice presidency.
  11. By the end of January, 1998, further steps were taken on bank restructuring with the granting of a full guarantee for all bank depositors, and creditors, together with the introduction of the Indonesian Bank Restructuring Agency (IBRA).
  12. The monetary crisis was further compounded by the distraction of the Currency Board System (CBS) proposal, followed by negative public reactions during the month of February, 1998.
  13. On March 23, 1998, the government took steps to raise SBI rates from 22% to 45% for the one-month rate.
  14. On April 4, 1998, the government announced the decision to freeze seven banks and to place an additional seven banks under intensive watch by IBRA.
  15. The third Letter of Intent with the IMF, signed on April 8, 1998, included additional features on social safety nets and steps to be taken on private corporate debts.
  16. On May 21, 1998, under intensive political pressure following the May 13-14 riots in Jakarta, President Suharto resigned and was replaced by Vice President Habibie.
  17. On May 23, President Habibie announced his Reformation Cabinet and the decision to give BI an independent status.
  18. An agreement on private sector debt was reached in Frankfurt on June 4, 1998, after two previous meetings in Tokyo and New York.
  19. The fourth Letter of Intent with the IMF was signed on June 24, 1998.
  20. The second disbursement of the IMF loan was made ($1 billion), an additional IMF loan was granted for social safety nets, and further budget revision were made.
  21. The Indonesian Debt Restructuring Agency (INDRA) was formed.
  22. The CGI Meeting in Paris resulted in a new loan of $ 8 billion which could be disbursed during the fiscal year 1998/99 and additional loans were granted to finance the budget deficit of $ 12 billion.
  23. The fifth Letter of Intent to the IMF was signed on August 7, 1998.

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 shift in market sentiment was demonstrated by the rapid downgrading process of the region's sovereign credit ratings, and the disappearance of the term 'Asian miracle' to be replaced by 'crisis', 'chaos' and 'meltdown'. But, the most telling was the Institute of International Finance's publication on capital flows for Thailand, Malaysia, Indonesia, the Philippines, and South Korea, which showed a dramatic shift from inflows of $93 billion in 1996 to outflows of $12 billion in 1997, or a change of capital flows of $105 billion. As I mentioned before, for Indonesia, the reversed capital flows of last year was estimated to reach $22 billion.

Confronted with the contagion effects, the national economy which 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.

In a similar fashion, the spread from economic crisis to a social and political crisis was through a contagious process, facilitated by inherent weaknesses in our social and political systems.
A more careful study on the causes of the collapse of the Indonesian economy over the past year has to be conducted. However, it seems clear that a combination of political and economic, external as well as domestic factors had been at work such that when a contagious effect from the Thai baht devaluation hit the rupiah, the Indonesian economy crumbled.


1 The CGI is organized by the World Bank since 1992 - it was established previously in 1967 under the Chairmanship of the Government of the Netherlands - comprising of 18 bilateral countries plus 11 multilateral and financial institutions of donors or creditors to the Indonesian Government.
2 World Bank, Addressing The Social Impact of the Crisis in Indonesia, a background note for the 1998 CGI, Paris, July 29&30, 1998 (mimeo).
3 This part is an update of a paper written before, Banking System Soundness and Macroeconomic Management : The Recent Indonesian Experience, for a symposium conducted by the IMF Office in Tokyo and the University of Kobe, "Towards the Restoration of Sound Banking System in Japan - Its Global Implication", Kobe, July 14, 1998.
4 Experts distinguish between banking distress, when a number of banks suffering insolvency problem, even though not liquidity problem, from banking crisis. Banking crisis is defined as a situation in which a significant group of banks have liabilities exceeding the market value of their assets, leading to runs and other portfolio shifts, collapse of some banks, and government intervention. Read, V. Sundararajan and Tomas J.T. Balino, eds., Banking Crisis : Cases and Issues, Washington DC : IMF, 1991, p.3.

COPING WITH THE CRISIS

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 on the same day the Philippine peso was floated, and more than a week after the Thai baht. However, a completely different reaction came from the market. On previous occasions, every time Bank Indonesia widen the intervention bands - 5 times since 1994 - the rupiah had appreciated. In fact, previously the dollar spot exchange rate closely followed the buying rate of Bank Indonesia. But, this time, the rupiah depreciated after the bands were widen. The spot rate of the dollar not only broken through the mid-rate, but it also broke through the selling rate or the upper band. The latter prompted Bank Indonesia to intervene in the market. It could now be said that what happened in July 1997 was definitely different from previous periods of pressure in the currency market; it was, actually, the contagion effects in progress 5. This is basically 'the wake up call' argument for the Asian crisis; since investors were convinced about similar weak conditions in a number of countries in Asia, (such as crony capitalism practices and weak financial systems) then their 'herd instinct' dictated that they should move their capital out of Asia.

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 theseefforts could not strengthen the rupiah, Bank Indonesia discarded the system of a managed float, and floated the rupiah freely in mid August 1997. These were done with the support of monetary tightening through interest rates policy, sterilization as well as fiscal tightening. But, partly due to the monetary and fiscal tightening, the weak banking sector started to suffer from distress. Some banks even suffered from bank runs as early as August 1997.

Realizing the fact that the problem had spread to the banking sector, 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 sector. This was a precursor of an IMF-supported program which came later, at the end of October 1997.

The IMF-supported program initiated with the first Letter of Intent with a Memorandum on Economic and Financial Policies (MEFP), which was submitted to the Fund on October 31, 1997, 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 macroeconomic management to cope with exchange rates and other monetary variable issues together with fiscal ramifications.

The core of the program was comprised of a comprehensive policy package to deal with insolvent and weak banks and the financial infrastructure, including the strengthening of banking supervision, and to overcome structural rigidities in the real sector of the 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, namely :

  • a strong macroeconomic 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.

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 return confidence to the banking sector instead resulted in the collapse of confidence which plunged the banking sector into chaos. The banking sector has 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.

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 closing of the 16 insolvent banks was lauded by the market, the foreign market 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, 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.

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. This was how market confidence evaporated in the government's commitment to the program for economic restructuring. 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.

In close to three 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 having some success on this score. But, has he been successful in eliminating the loss of confidence in the national leadership to be able to lead the government and the nation to implement the national program for restructuring economic and political lives in Indonesia ? Well, may be to raise this question at present is a bit unfair. On the other hand, so many problems that Indonesia is presently confronting cannot wait for the right solutions.

Despite the good publicity that President Habibie has been receiving so far, the market has not been impressed with his leadership. Economic problems have not abated. In fact, statistics on maroeconomic indicators have shown a gloomier picture in terms of GDP growth prospects, the inflation rate, the budget deficit, and the situation with regard to food and other basic commodities. The rupiah has been strengthening somewhat, possibly due to some encouraging news recently about the 8 billion dollar loan for fast disbursement from the CGI. But, the bad news from Japan and its implication for Asia, and the still unclear government position about some social issues, seems to have caused the lukewarm attitude of the market so far. Investors and creditors keep saying that they still want to wait for the return of social and political stability first before they are willing to invest in or lend to Indonesia. They trust the long term potential, but are waiting for some time before resuming their activities in Indonesia. In other words, despite the positive public reception to some statements or steps that President Habibie has recently made, questions are still being raised, if not on whether he is sincere, but on whether he is able to deliver.


5 The previous external shocks were occasioned by the impact of the Mexican crisis in January 1996 and the strengthening of yen in April 1996. In both occasions, the rupiah was weakened, but it recovered within days.

BANKING SOUNDNESS AND MONETARY POLICY

As stated in the IMF supported program for economic reform, essentially the program is comprised of economic restructuring of the real sectors, and financial restructuring, complemented by prudent fiscal and monetary policy. This is then extended to include steps to address problems related to subsidies for the social safety- nets and private sector debt overhang. The real sector reforms, including privatization, are aimed at reducing inefficiencies in the economy, uprooting monopolistic and oligopolistic practices, increasing transparency and abolishing corruption.

Many studies have clearly shown the close link between the soundness of the banking system, which is the subject of microeconomic analyses, and monetary policy, which belongs to macroeconomics. Neither effective monetary policy for achieving monetary stability, nor well managed macroeconomic policy for achieving growth and stability, can be sustainable without the existence of a sound banking system. It is further argued that banking soundness should be treated as an objective for monetary policy, together with price - and exchange rate - stability. Manuel Guitian wrote that "Systemic bank soundness is now seen as a component of monetary management, as a complement to macroeconomic policy in general, and as a policy objective in its own right for the pursuit of economic balance and stability".6

In the meantime it has been documented that since 1980 up until just before the Asian crisis broke out in July last year, over 130 countries had experienced banking problems, either significant banking problems or banking distress and banking crises. It also appears to be a fact that more problems had been observed in the latter part of this period, and that both the nature and the intensity of the problems as well as their ramifications had been increasingly severe 7. This seems to indicate that, despite increasing awareness about the close link between the micro and macro aspects of monetary policy, over time more countries have been experiencing banking problems and the problems are becoming more serious while their impacts are worsening.

The above development has contributed to the many studies conducted and resolutions and policy proposals made to cope with the problems 8. The latter came notably from the G-7 communiqué after the Lyon Summit in June 1996 and the Interim Committee's Declaration, Partnership for Sustainable Growth, in September 1996.

It may be important to reiterate at the outset the proposition that, "an appropriate macroeconomic policy stance is unlikely to be sufficient to maintain balance in the economy unless it is supported by sound underlying microeconomic conditions". This is true on the fiscal front as well as in the area of monetary policy, be it in exchange rate management, external debt-management, or in the focus of our discussion in this symposium, the area of monetary policy and banking soundness. These propositions have been recognized and widely accepted. As I mentioned, they have developed from past experiences in many Latin American countries in the early eighties, savings and loans associations' problems in the United States, exchange rates problems in Europe with the Exchange Rate Mechanisms (ERM) experiment, the Mexican crisis, and several others. 10

It is a bit of an irony that Managing Director Camdessus, in his closing speech of the International Monetary Fund (IMF) seminar on central banking at the beginning of 1997 said that "Last year I said that I suspected the next international economic crisis would begin with a banking crisis or almost certainly be compounded by one. Let us hope that all of our efforts to increase the awareness of financial sector problems and to seek solutions to them will lead to serious reforms - both nationally and internationally - that promote sound banking and market discipline. Through these efforts, including events such as this seminar, we can substantially reduce the possibility of my suspicions becoming reality." 11 It turned out that the Asian crisis was already in the making then.


6 See, Manuel Guitian, Banking Soundness: The Other Dimension of Monetary Policy, in Banking Soundness and Monetary Policy: Issues and Experiences in the Global Economy, Charles Enoch and John H. Green, eds., Washington, DC : International Monetary Fund, 1997 pp 41-68.

7 See, Carl-John Lindgren, et al., Bank Soundness and Macroeconomic Policy, Washington, DC: IMF, 1996, table 2, and Stanley Fischer, Bank Soundness and the Role of the Fund, in Charles Enoch and John H. Green, Banking….p.22.

8 I found the two books published by the IMF I mentioned before plus an earlier book edited by V. Sundararajan and Tomas J.T. Balino, Banking Crisis : Cases and Issues, Washington, : International Monetary Fund, 1991; are very instructive for all of us who are interested in this subject. I think, these books and many seminars or workshops on problems of banking soundness and monetary policy have been well serving to socialize this very important issues for economic management of to day.

8 See Preface and Part I of the book, Carl-John Lindgren et.al. , Bank Soundness and Macroeconomic Policy.

9 See, Morris Goldstein and Dennis Weatherstone, The Asian Financial Crisis, Institute for International Economics, Policy Brief 98-1, March 30, 1998.

10 Michel Camdessus, The Challenges of a Sound Banking System, Charles Enoch and John H. Green, Banking Soundness………p.539

MACRO MANAGEMENT FOR ECONOMIC RECOVERY

Basically, monetary policy is aimed at price stability, in terms of domestic prices and the control of inflation and exchange rates. In the Indonesian context, this has to be done in conjunction with policies to bring about a more sustainable current account of the balance of payments, to manage external debt and to develop borrowing strategies, as well as to maintain sufficient foreign exchange reserves. Furthermore, monetary policy has been conducted in cooperation with fiscal policy to form macroeconomic management for balanced development. However, confronted with the crisis, monetary policy, together with fiscal policy, are to support real sector structural reform and financial restructuring for economic recovery.

The IMF supported program for economic recovery can be followed from a Memorandum on Economic and Financial Policies (MEFP) with a covering letter to the IMF, popularly known as the Letter of Intent. The program is comprised of the followings:

  • Real sector structural reform which is comprised of four areas: dismantling monopolies, deregulation measures, trade and investment liberalization, and privatization.
  • Bank restructuring with four areas of concentration, namely:
  • (i) the closure and liquidation of the weakest banks with government guarantees to depositors and creditors;
    (ii) the rehabilitation of the weaker of the remaining banks through the disposal of bad loans and bad assets, mergers, and the infusion of government capital;
    (iii) the strengthening of the relatively better banks again through the disposal of bad loans and through recapitalization by the government as well as by private foreign and domestic investors with no limits on a foreign ownership. These banks will form the core of the new system; and
    (iv) the negotiated resolution of the debt of domestic corporations to domestic banks. This will be done in conjunction with case by case workouts to restructure the external debt of these corporation. The new bankcruptcy law should ensure that both parties come to the negotiating table.
  • Fiscal policy which includes a substantially increased subsidy because of the continued depreciation of the rupiah and the cancellation of further price increases for basic foodstuffs, petroleum products and electricity, increased expenditure for health and education, and the expansion of employment-creating investment projects at the community level.
  • Maintaining tight monetary policy with no growth in base money and NDA to strengthen the rupiah and to bring inflation down quickly.

The policies implemented by the monetary authority to cope with the problems confronting the economy since the currency shock of last year have been itemized in the section explaining the chronology of the crisis. It has also been discussed in the section analyzing the link between banking soundness and monetary management. Suffice it here just to raise some issues related to certain steps that have been taken so far to address the problems. These are some of them :

  • on the floating of the rupiah; questions have been raised on why the monetary authority decided on it, instead of maintaining a managed floating system with a wider bands of intervention. Another question has been raised on the implementation of a fixed exchange system, with or without a currency board arrangement. These are issues related to the type of foreign exchange system to be implemented. With the devastating impact of the collapse of the rupiah on practically every aspect of our economy, the public pressure for abandoning the current floating exchange system has been strong.
  • on the capital flows and private debts; why has the monetary authority not resorting to administrative control. The pressure on the issue for foreign exchange controls or controls on capital flows has also been mounting, especially since Malaysia announced this policy and after Professor Krugman suggested in his article in Fortune magazine.
  • on the tight monetary policy and high interest rates for exchange rate management at the cost of the real sector.
  • on the role of the IMF in macroeconomic management, and
  • on giving more autonomy to the central bank.
BANKING RESTRUCTURING IN INDONESIA

It has been conjectured that banking soundness is vital for a sustainable macro-economic management of a national economy. Despite the continuous competition from other financial intermediaries as a result of the globalisation process, the banking sector still plays a dominant role in a national economy, particularly in developing countries. The condition of the banking sector generally reflects the status of the financial sector as a whole. Thus there is the over-riding concern over bank soundness.

According to the IMF Executive Board, efforts to strengthen the banking system should be guided by the following principles: 12

  • the soundness of a bank is first and foremost the responsibility of its owners and managers; yet the soundness of a banking system is a public policy concern;
  • bank soundness is crucially linked to sound macroeconomic policies;
  • a framework for sound banking must include structures to support internal governance and market discipline, as well as official regulation and supervision; and
  • international cooperation and coordination can play an important role, not only in strengthening the global financial system, but also in improving the soundness of the national banking system.

Let me summarize how banking restructuring was conducted in Indonesia with a view to the principles mentioned before. Before the current banking crisis, the most recent experience of dealing with problematic banks was the closure of Bank Summa, a sizable bank, at the end of 1992. A significant number of banks, including most state banks, were faced with serious non-performing loans, partly due to the drastic monetary policy implemented during 1991-1992 to halt the overheating of the economy. The IMF classified the condition of Indonesian banks then as experiencing significant problems. The closure of Bank Summa was a distressing experience since it took a long time to be resolved. However, in the course of time, conditions improved as shown by the national average of non-performing loans, which declined from 25% of total lending in 1993 to 12% in 1995. 13

The banking crisis was preceded by a short period of distress when, due to a process of erosion of confidence, banks lost their deposit bases. In addition, the inter-bank money market functioned poorly, in that it suffered from compartmentalization. Weak banks had to rely on Bank Indonesia to keep afloat. Confidence was completely lost when "flight to quality" was rampant and a substantial number of banks were confronted with bank-runs within a short period. Strangely, in the recent Indonesian experience, these phenomena happened following the closure of the 16 banks in early November 1997, which was originally designed to boost confidence in the banking system. Individually, a bank confronted with a problem of mismatched liquidity could easily become insolvent. For the banking sector, the problem changed from distress to crisis.

When the currency crisis spread to inflict the national economy, the government's efforts to address the banking problems were combined with other policies and treated as part and parcel of the adjustment policies for stability and sustaining growth. But, this treatment was more explicit in the IMF supported programs, from the first Letter of Intent in November 1997 to the most recent (the fourth) in June 1998.

The Indonesian government asked for a three-year stand-by loan from the IMF, which was processed through an emergency procedure. The amount of the stand-by loan is SDR 7.3 billion, and together with those provided by the World Bank and the Asian Development Bank, the total loans amounted to US$18 billion. This amount, plus US$5 billion of Indonesia's own reserves set aside for balance of payments support, makes a total of US$23 billion available to be drawn. Together with bilateral facilities in the second line of defence the total amount of the rescue package amounts to US$43 billion.

Basically, the IMF supported program was comprised of a comprehensive policy package to deal with insolvent and weak banks, and to overcome structural rigidities in the economy, supported by prudent fiscal and monetary policy. The financial restructuring program which had been put together with technical assistance from the IMF, the World Bank, and the ADB to restore public confidence in the financial system was comprised of five parts, namely:

  • the closure of 16 insolvent banks, which was executed on November 1, 1998.
  • the establishment of proper procedures and policies to deal promptly with weak but viable financial institutions, so that they can be placed quickly on the road to recovery; some banks were to be put under intensive supervision by BI.
  • the resolution of specific problems of state and regional development banks.
  • the strengthening of the institutional, legal and regulatory frameworks for banking operations to ensure the emergence of a sound and efficient financial system; this program includes the modification of such laws as the central bank law, the law on bank liquidation, and the bankruptcy law.
  • the establishment of Indonesia Bank Restructuring Agency (IBRA), after the second Lletter of Intent.

The program of banking restructuring was part and parcel of a comprehensive program that comprises both the real and financial sectors, supported by prudent fiscal and monetary policy.
If we look at what was put into the program, one could argue that the right steps were taken to address the Indonesian crisis. But, why is Indonesia's IMF supported program showing negative results thus far? In comparison with the implementation of other IMF supported programs, the Indonesian case is definitely the worst, particularly when one compares the rate of currency depreciation, growth prospects, inflation, and the development of other variables in the respective countries.

The process remains underway, so any analysis will not give a conclusive explanations. However, some observations could be presented below as lessons to be learned, in anticipation of further detailed studies.


12 Carl-John Lindgren, et al. Bank Soundness and Macroeconomic Policy, ……p.5
13 See, Carl-Johan Lindgren, et al., Bank Soundness………, table 2, page 26. On the main issues confronting Indonesia in coping with banking system management and banking reform prior to the present crisis, see my paper, The Banking Sector in Emerging Markets : The Case of Indonesia, published in Charles Enoch and John H. Green, eds., Banking Soundness………, pp 335-352.

TOWARDS A SOUND BANKING SYSTEM

As I mentioned above, the IMF supported program that Indonesia is implementing includes a comprehensive restructuring of the banking system. With the help of the ADB, the World Bank and the IMF, IBRA is working to address the problems of the weak banks through a combination of mergers, recapitalization and ceasing the operations of insolvent banks. The bad loans of the banks are to be transferred to an Asset Management Unit (AMU) to be established within IBRA.

To strengthen relatively sound banks, schemes will be announced soon which will allow banks that achieve a special increase in capital can sell their bad loans to the AMU so that they can improve their CAR. In addition, a provision will be made for the creation of tier two capital in the form of subordinated loans to banks whose capital has been increased by their owners.

Discussions are under way with foreign banks regarding investment in the banking sector. To facilitate the process all restrictions on foreign ownership of banks will be lifted as part of the prospective amendments to the banking law. As an interim measure, foreign bankers will be retained to strengthen the management of banks under IBRA's control.

All banks are to achieve minimum capital adequacy ratios of 4 percent of risk-weighted assets by the end of 1998, rising to 8 percent by the end of 1999 and 10 percent by the end of 2000.

These are, of course, necessary steps to get the banking sector back to a normal footing, i.e. being solvent. However, for the banking system to be sound most banks should be solvent and are likely to remain so. The IMF stipulates that the likelihood of remaining solvent will depend, inter alia, on banks' being profitable, well managed, and sufficiently well capitalized to withstand adverse events 14. But, aside from the fact that the banking sector has to be sound, all infrastructures - namely regulations, prudential measures, disclosures, accounting practices and the legal base - to support the industry have to be working well. Manuel Guitian, mentions the three-pillar paradigm for banking soundness, namely official oversight (the prudential standard), internal governance (risk management in each individual bank), and market discipline (sound banking practices). But, this paradigm still has to be complemented with adherence to several principles for strengthening the banking system: responsible owners and managers of banks and professional authorities, prudent macro management and, in a globalized financial system, good international cooperation.

The problems that the Indonesian banking system is presently facing seem to be very complicated indeed. The steps which need to be taken are often problematic. In a way, measures which had been taken all these years to put the prudential regulations in place were wiped out by the crisis. At the same time, an opportunity arises to put all the necessary pillars for sound banking system in place. A comprehensive program towards that seems to be in place. What has to follow is the discipline to implement the program.


14 Carl-Johan Lindgren, et al., Bank Soundness and Macroeconomic Policy,…….p.9

SOME PROSPECTS FOR RECOVERY

To get the economy back to normal we first have to be out of the crisis. However, to be able to get out of the crisis we have to have a clear picture of the entire problem, as well as of the link between one particular sector and the others, including politics. This does not mean that everything has to be done at the same time, since it is impossible to solve all the problems simultaneously. Some priority has to be made to plan the path for recovery. Facing a crisis originating from a process of contagion, time is of the essence. The sooner the authorities can act the better. The sooner we recognize the problems, the sooner we come up with good programs, and the sooner we have effective implementation - and hopefully helped by a touch of luck - the better will be the chance for success.

Granted that a promise for political reform could lead to some state of stability, the economic program for recovery will have to include steps to address the following problems:

  • Disciplined implementation of IMF-supported programs. With the four Letters of Intent, a much better understanding between the Government and the Fund seems to prevail. A commitment from the Government for no backsliding of program implementation and a more adaptable attitude from the Fund would be helpful
  • More consistent steps for the implementation of the banking restructuring program, for the insolvent, the weak and the healthy banks.
  • Consistent follow-up steps for a solution to corporate debts and banks' debts, including trade financing and money line facilities.
  • A fiscal and monetary stance which could support the restructuring programs without constraining stability.
  • Steps to revive export and tourism activities. At a time when foreign investors are still taking a 'wait and see attitude', the promotion of tourism does not have to wait.

These steps could be taken smoothly, provided that progress has been made on addressing the more immediate problems of food supply and food distribution. The basic problem here is how to maintain the availability and affordability of key commodities important to the poor. With respect to supply problems, the foreign commitments made through the CGI and other channels have to be consistently implemented. But, for the distribution problems, the government has to realize the seriousness of the damage done to the distribution system following the burning, looting and raping, particularly against the Chinese, during the recent riots. The fact that so many ethnic Chinese fled the country, taking their capital with them, has been very damaging to the distribution system, because of their prominent role in this sector of the economy. Without some assurance about their safety from the government using our security forces, it seems unrealistic to expect them to come back and resume their business activities. The government program to enhance small businesses and cooperatives will take time, if it is implemented effectively. I do not see any problem in designing a reservation scheme to create a better balance for a more sustainable business climate in Indonesia in the future, encompassing all potentials in a competitive market.

But the linchpin of all the above issues is still the stability of the Rupiah at a reasonable rate.

Some progress has been made by the Government in addressing these pressing problems, but the market has still not made any positive move. In my view, this actually means that somehow 'a turn around' still has to come before the market players - the traders, investors, and creditors - are willing to act positively to the development of the Indonesian economy.

The positive response from the market has to be preceded by a positive perception, which has not come out yet. A positive perception could come when market confidence is back. John Maynard Keynes showed us 62 years ago about the importance of confidence in an investment decision, aside from the marginal efficiency of capital. However, it is difficult to define what confidence really means. I could only say that, indeed, market confidence is crucial. Confidence is very difficult to describe. We will only know how crucial it is when we do not have it. When confidence is present the market is not very demanding. However when it is lost, everything we do is not good enough, and the market is extreme.

The turn around has to be produced by the government by showing the market how the government views the totality of the problems facing our country and showing that it has a credible rehabilitation program to be implemented. This has to be done to get public support for the implementation of the program. The most important step, however, is to change the negative perception of the market - in other words to get rid of the confidence problem, to change the market's "wait and see" attitude - to become positive. After that, a consistent implementation of the program, plus hopefully a touch of luck, the long path towards recovery could be assured.

SOME LESSONS TO BE LEARNED

The Asian crisis which has been lingering on for a little over a year now, shows that globalisation has brought both ample opportunities and risks. Indonesia, together with Thailand and Korea in particular, and other countries have benefited substantially from the openness of the respective economies as well as the huge inflows of capital since the beginning of the nineties. However, weak financial systems and sudden changes in market sentiment (from optimist to pessimist) seem to enable an external shock to create a banking crisis, and then a total all-encompassing crisis, including economics, social and political issues, in a short time. I have showed you how the crisis unfolded in Indonesia.

From both the process of how the problems arose and the policies that the authorities are implementing, lessons could certainly be learned for future monetary and financial management of economies in Asean, and to a certain degree India. The following points are lessons which we could learn from the crisis and steps in monetary and banking policy which could be implemented:

  1. Regarding financial development prior to the crisis, some lessons from financial liberalization, which for Indonesia was done in the eighties and nineties, are in order. Banking liberalization has to be done in coordination with the improvement of the financial infrastructure, including proper regulation and strict prudential measures, adequate disclosure, governance, legal protection, and market discipline. Studies have also shown the possible sequencing of financial liberalization, even though different condition may require a different sequence. 15
  2. On the liberalization of capital flows, Indonesia's experience has put the thing on its head, since the rupiah has been fully convertible since the seventies and there are practically no measures to control capital flows. I think some caution articulated by Professor Bhagwati in the recent Foreign Affairs has to be considered. 16
  3. Lessons from the crisis in the eighties are still valid here, namely that the sooner the better and the problems are always worse than expected.17 This seems to be true for both monetary policy and banking reform. A study of Indonesia's banking problems and the steps taken to resolve them, undertaken by the Monetary and Exchange Affairs Department of the IMF in 1996, indicates that in terms of both the number of problem banks and the cost for their restructuring, the current figures are much larger than previously. Basically, the sooner the problems are identified, recognized and properly treated, the better the chances for being successful, and the smaller the cost involved. 18
  4. On banking soundness as a requisite for sustainable monetary policy, I would argue that the Indonesian experience supports it. We may even 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 payments system. I think the inclusion of banking soundness as an explicit objective of monetary policy is in order.
  5. In an effort to create a sound banking system by implementing a program that combines banking restructuring and monetary management, we have to be very cautious about the fact that we are working with variables which are different in terms of their time frame. Monetary policy in general is a short run issue, dealing with short run variables, even though it has long term implications. Tight or loose monetary policy is a short run issue. It deals with macroeconomics 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 microeconomics issues. These have to be considered carefully in designing and implementing banking reform together with monetary policy. In addition, as Manuel Guitian argues, there are interaction and feedback effects between bank soundness and macroeconomic policy choices. Conflicts between the aims of price stability and bank soundness entail an intertemporal trade-off. 19
  6. The Indonesian experience also teaches us that when public expectation (in this case the domestic market) is fragile, the closure of insolvent banks, even though 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 confidence. It may not be realistic, but the liquidation of banks should be done when the economy is not fragile. And, in general, the sooner the better. The sooner the authority identifies the problems, the sooner the authority accepts the reality about the problems, and the sooner a well prepared restructuring steps are implemented, the better. Why? Because it will be less costly, and the chance for success is better.
  7. I cannot help but observe that, even though there has been an increasing awareness of the close link between banking soundness and macroeconomic policy - banking soundness is a conditio sine qua non for sustainable monetary policy -, partly due to the socialization campaign by the IMF and others, it has not adequately prepared monetary authorities and market players in developing countries to cope with the crisis. This lack of preparation has created devastating impacts, especially in Thailand, Korea and Indonesia.
  8. In the Indonesia's case, the monetary authority had been endeavoring to take steps to strengthen the banking system before the crisis, including reorganizing banking supervision, developing 'self regulating banking systems', raising reserve requirements, curbing credit expansion for property, etc. to prepare for the uncertainties. It seemed the monetary authority had been taking steps in the right direction to cope with possible external shocks. But, the crisis was so devastating that what the monetary authority did, even if it was right, was just too little and too late.

15 See, for example, Ronald McKinnon, The Order of Economic Liberalization, (Baltimore: The John Hopkins University Press,1991)
16 See Jagdish Bhagwati, 'The Capital Myth' in Foreign Affairs, May/June 1998, pp. 7-13.
17 See, Andrew Sheng, The Crisis of Money in the 21st Century, City University of Hongkong Guest Lecture, 21 April, 1998.
18 See also, Stanley Fischer, Banking Soundness and the Role of the Fund, in Charles Enoch and John H. Green, eds., Banking Soundness…….p.23.
19 See Manuel Guitian, Banking Soundness: The Other Dimension of Monetary Policy, in Charles Enoch and John H. Green, eds., Banking Soundness and Monetary Policy,……. P 48.

CONCLUDING NOTES

I have been discussing the Indonesian experience with economic crisis, with particular reference to monetary policy and the banking system. Since my understanding of India's financial structure and monetary policy is minimal, I would not wish to make any firm suggestions or recommendations on these matters to you. However, I am sure that by studying carefully the Indonesian experience as it unfolds, in terms of the problems confronting our economy, the steps taken to address these problems and the market's reactions to them, there are areas in which other countries, including India, could learn to avoid similar mistakes.

The lessons that we have learned the hard way, particularly with regard to financial liberalization, capital liberalization, bank liquidation, floating our currency, resolving private corporate debts and the involvement in an IMF supported program, could be very instructive for India and other countries.

Indonesia is still struggling to stop the downward spiral and turn the crisis around towards recovery. I am sure that through a better understanding, guided by friendship and cooperation between Indonesia and Southeast Asia on the one hand and India on the other, we can build a new economic era with +more solid fundamentals to face similar crises in the future.

[index]