NATURE AND CAUSES OF THE CRISIS IN INTERNATIONAL FINANCIAL MARKETS:
Perspectives from Southeast Asia.

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


A presentation at the Third MEFMI Central Bank Governors Forum, Surrey, UK, May 31, 1999

-oOo-

THE CRISIS

  • There have been so many conferences and writings on the Asian crisis, discussing about the nature and causes of the crisis, its implications as well as lessons to be learned from it. One could be sure that studies about the crisis and its implications would still be continued in the years to come. This is due to the fact that despite the attention that it received, the crisis has been going on for a period longer than people thought. And the effects have been more devastating than most people expected. As we have been observing, the Asian crisis has been followed by Russian and Brazilian crisis.

  • Recent development has shown encouraging signs as voiced by recent mid-year meetings of the Fund and WB in Washington DC. The crisis seems to be behind us, as reported at the IMF Interim Committee meeting that in the three hardest hit countries in Asia, there has been economic recovery in Korea, the crisis in Thailand is bottoming out and Indonesia is expected to follow. Brazil is reported to be out of the crisis, while Russia is close to getting back to having IMF supported programs.

  • The current views on causes of the crisis could be separated into two. First, those who look at the origin of the crisis as domestically grown, arising from practices of crony capitalism and weak financial structures plus inept macro policies. Second, those who look at the crisis as triggered by a shift in the market sentiment, or from an external factor, as the origin of the crisis. The first view could be considered as the structural argument of the crisis as some, like professor Krugman of MIT used to argue. The second view argues that the crisis is basically a financial panic in the Keynesian tradition as succinctly explained by professor Kindleberger in his seminal work, Manias, Panics, and Crashes: A History of Financial Crises, 1978. Professor Jeffrey Sachs has been the strongest proponent of this view.

  • It is my view that the Asian crisis, in particular the Indonesian crisis comes out from a combination of the work of contagion forces from outside the national economy on the one hand and weak domestic economic and financial structures on the other. The contagion factor of the crisis was emanating from a sudden change in market sentiment in the region that led to a shock in the currency markets of the region. This had led to panic selling of local currencies for dollars. The shift in market sentiment was demonstrated by the rapid downgrading process of the region's sovereign credit ratings and, in the media, the disappearance of the term 'Asian miracle' to be replaced by 'crisis', or '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. The estimate showed a reversal flows of capital of $105 billion in these five countries in a single year, from inflows of $93 billion in 1996 to outflows of $12 billion in 1997. For Indonesia alone, the reversed capital flow was estimated to reach $22 billion, from inflows of $ 10 billion to outflows of $12 billion. This has been the financial panic in the Keynesian tradition as explained by Kindleberger. But, the external shock itself does not have to cause a crisis of the magnitude that these countries suffer, if only their domestic economic, as well as social and political structures are robust.

  • Confronted with the contagion effects, the Indonesian 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. Hence, my contention about a combination of both external shock and structural weaknesses that caused the work of contagion.

  • In the Indonesian case, the contagion process had been working not just across geographical or national borders. Within a country, it trespassed different aspects, from economic to social and political. In Indonesia, the spread from economic crisis to a social and political crisis was also through a contagious process, which was facilitated by inherent weaknesses in the social and political systems of Indonesia. A more careful study on the causes of the collapse of the Indonesian economy recently 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 in mid July 1997, the Indonesian economy was collapsing.

  • In Indonesia, we could say that the external contagion that hit financial market served to expose weaknesses of Indonesia's banking system that resulted in banking crisis. In turn, the banking crisis that seeped through the payment system uncovered weaknesses in the real sectors of Indonesian economy that was embedded with inefficiencies and corruption from the practice of 'crony capitalism' to result in an economic crisis. And finally, the economic crisis exposed institutional weaknesses in Indonesia's social and political system and they were both collapsing in a total crisis.


NATURE OF THE CRISIS

  1. But, how did the crisis develop? Basically, the Indonesian crisis originated from an ordinary currency problem, when rupiah suffered from sudden pressure in July of 1997, immediately after the floating of 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.

  2. 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, took the decision to further widen the bands, from 8% to 12% on July 11, 1997, the day the Philippine peso was floated. It should be mentioned here that Indonesia implemented a policy of managed floating of its currency with creeping depreciation, via a reliance on a mechanism of adjustable intervention bands. Bank Indonesia, the Central Bank would intervene the currency market every time the market rates crossed the bands. The bands had been widened six times between 1994 to the previous move in July 1997. The market reaction to the Central Bank's policy in July 1997 was in contrast to its past pattern. Previously, every time the BI intervention bands were widened 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 was 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.1

    • The spreading of economic crisis to social and political crisis also went through contagion. When economic recession became a reality, social unrest broke out everywhere and public confidence on the government and the national leadership evaporated very rapidly, due to weaknesses in both the social and political foundation of Indonesia. And thus, from an economic crisis Indonesia suffered a full-fledged crisis that caused so much of human sufferings.


SOME NOTES

  1. Despite some arguments for single variable cause of the crisis, either external shock in the nature of financial panic or domestic structural weakness of crony capitalism, I would like to argue that the Asian crisis is caused by an external shock in the currency market hitting Asian economies embedded with structural weaknesses. It is the work of contagion working from financial panic to total crisis because of a combination between external shock and domestic structural weaknesses. It is definitely not a crisis with single variable cause.

  2. The Asian crisis is not just a financial market or economic crisis, but a multi faceted crisis, involving economic, social and political lives. Some similar characteristics of the crisis, at least in Indonesia, Thailand and Korea, are that these countries face with severe problems of short-term corporate debts and unsound banking system coupled with, different nature of, social and political problems. The Asian crisis is not just financial or economic crisis in nature.

  3. All these countries asked for assistance from the Bretton Woods Institutions, the Asian Development Bank as well as from bilateral relations. The Indonesian case is the worst, in terms of the currency depreciation, the growth reversals, the social and political dislocations, even though it has a better conditions at the beginning of the crisis.


@ Visiting Scholar, Harvard Institute for International Development (HIID), Cambridge, MA and former Governor of Bank Indonesia. (sdjiwand@hiid.harvard.edu or djiwandono@aol.com).

1 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.



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