THE RUPIAH - ONE YEAR AFTER THE FLOAT

by J. Soedradjad Djiwandono


Pointers for an address to be delivered at a luncheon organized by The Indonesia Australia Business Council Jakarta, August 11, 1998.

-oOo-

INTRODUCTION

It is a pleasure and privilege for me to address such a distinguished group of business persons, members and guests of the Indonesia Australia Business Council, on a topic which has become one of the most talked about in town, the problem of Rupiah. But, despite all the discussions, it remained somehow not very clear as to what have actually been the causes of the unprecedented depreciation of a currency in such a short period. It seems to even be less clearer if one wants to get an answer on the question of what would be its fate in the near future, what would be the 'equilibrium level' of its rate in terms of dollar or other currencies. Most of us want to see the rupiah rate strengthening, but at what level and how could we achieve that are more difficult questions to answer.
However, one cannot get to the core of the problem of the dramatic collapse of the rupiah rate without analyzing it in a wider context of the economic and social as well as political crisis which has been confronting Indonesia in the last more than a year. And this will be my approach in discussing the topic; The Rupiah - One Year After the Float. By looking at how the crisis has actually been evolving; identifying the origin of the crisis, steps taken by the government in coping with the problem and their implications, a better understanding about the actual problem could be derived. This will, hopefully, shed some lights on the rupiah problem for a better understanding about its future prospect. Another words, I will not discuss the rupiah itself.

FROM CURRENCY PROBLEM TO 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. It is certainly indisputable to argue that, among the three the Indonesia case is the worst.

If one looks at the process of how events in the Indonesian economy evolving to become economic and political crisis, it is clear that the Indonesian crisis was originating from an ordinary currency problem, when rupiah suffered from a sudden pressure in July of last year, after the weakening and the floating of the Thai baht in early July 1997. However, after some process of policy responses by the government and reactions from the market players, the problems had rapidly been spreading and deepening to effect all sectors of the national economy, before finally impacting politics.

Chronologically, the crisis could be traced as follows :

  • It started with the market pressure on the rupiah as part of the contagion effects from currency market imbalance in the region. Facing such a currency market pressure, the government, based on the current exchange rate management of managed floating and creeping depreciation, relying on a mechanism of intervention bands, which was adjusted continuously since 1994, took a decision to further widen the bands, from 8% to 12% on July 11, 1997; the day the Phillipnes' peso was floated.
  • The market reaction to Bank Indonesia move was contrary to the past pattern. In the previous experiences, every time the BI intervention bands were widened ( 5 times from 1994 to 1997 ) an appreciation of rupiah usually followed. However, this time rupiah was even rapidly depreciated instead. And when the spot rate was crossing BI selling rate, some intervention in the currency market was exercised.
  • Since in the process the market pressure was not abating, Bank Indonesia floated the rupiah in August 14, 1997. Interventions in both the forward and spot market were conducted. Monetary tightening, through monetary and fiscal means, was done after exercising market intervention.
  • After Bank Indonesia intervened the market several times and exercised monetary tightening, the problems spread to include the banking sector, and the banking industry started to experience distress. And, as the problems continued, the confidence toward the banking sector started to decline, and 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 rupiah, tiering of the interbank money market, and losing 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. Banking sector experiencing crisis, especially after the closing of the 16 insolvent banks. Thus, from currency shocks and crisis, through banking distress and crisis, finally resulted in a total economic crisis.
  • The impacts of economic crisis to politics and social lives had almost became self explaining, when economic recession became a reality, social unrest broke out everywhere and public confidence on the government and the national leadership was gone.

Analytically, the Indonesian crisis could be explained as originating from an external shock in the currency market, due to changes in market sentiment in the region that incited a contagious effects. The shift in market sentiments were shown in rapid downgrading process of the sovereign ratings, and the disappearance of the terms '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 was changed from inflows of $93 billion in 1996 to outflows of $12 billion in 1997. According to the World Bank report for the recent CGI meeting in Paris, the data on capital flows for Indonesia during this period was an inflow of $10 in 1996/97 to an outflow of $12 billion in 1997/98.

Confronted with the contagion effects, the national economy which had been suffering from inefficiency in the real sector ( a high cost or high ICOR economy, suffering from crony capitalism ) and a weak financial system, banking in particular, could not cope with the shock, and through a contagious process the weakening of Rupiah adversely affecting the financial sectors, and on to the real sectors. 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 social and political crisis was through a contagious process, facilitated by weaknesses in our social and political system.

COPING WITH THE CRISIS

The initial government response to the problems was prompt, starting with an immediate step to widen the central bank intervention bands in the foreign exchange market the same day the Philippines peso was floated, more than a week after the Thai baht. But, a completely different reaction came out from the market. In the previous instances, every times Bank Indonesia widen the intervention bands - 5times since 1994 - rupiah was appreciated. In fact, previously the dollar spot rate was mostly tightly close to Bank Indonesia buying rate. This time, rupiah was depreciated drastically after the bands was widen. It could now be said that, what happened in July 1997 was definitely different from the previous pressures in the currency market; it was, actually, the contagion effects in progress. This is basically what people meant by 'the wake up call' explanation of the Asian crisis. Foreign market players decided to shift their investment out from the region after observing weaknesses in the economic structures of the region - as a result of crony capitalism practices and the prevalent weak financial system.

Facing the persistent pressure on the rupiah, the government responded with market intervention, started with selling dollar forward, but later, also in the spot market. And when the effort could not strengthen the rupiah, Bank Indonesia discarded the system of managed floating, 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 banking sector started to suffer from a distress. Some banks were even suffering from bank runs.

Realizing the facts that the problem had been spreading to the banking sector, in early September 1997 the government launched a broad economic policy, encompassing, not just the 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), submitted to the Fund on October 31, 1997, 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 comprised of standard programs of macroeconomic management to cope with exchange rates and other monetary variables issues together with the fiscal ramifications.

The core of the program 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 policy framework was to put in place 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, and incorporating substantial fiscal adjustment as well as 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 the joint intervention in the currency market of 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 a 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 turn the confidence back to the banking sector, resulted in the collapse of confidence and plunging the banking sector into chaos. The banking sector suffered from 'the flight to safety and to quality' since then. Many banks loss their deposit base, inter bank money market suffered from compartmentalization, and since January 1998, letters of credit issued by Indonesian banks were denied abroad. The confidence problems in the national economy were basically involving three areas; the rupiah rate which was weakening drastically against the dollar, the banking sector which was losing the deposit base as well as the 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 of four letters of intent in seven months, and the social unrest spearheaded by continuous students' demonstrations, the confidence problem was shifting to the national leadership, not just economic. When Suharto was still in power the question was on his sincerity in implementing the difficult program. Actually, the closing of the 16 insolvent banks was lauded by the market, foreign market in particular. But domestically the closing of banks was badly received. It was even causing further loss of confidence on the banking system. And when some intervention by the government on the execution of the decision on bank closure was suspected, the foreign market started to react negatively also. This had basically transformed the banking sector from a state of distress into crisis when market confidence was almost completely lost.

The negative reaction on the implementation of the program was more pronounced when some reversal of decision on the postponement of a number of big government projects was announced plus the reappearance of monopoly practices and some other inconsistencies in the implementation of program for restructuring the real sector. This was how the market confidence on the government commitment to the program for economic restructuring evaporated. As a result, the rupiah slide downward was not just difficult to stop, but the economic crisis was rapidly shifting into total crisis in a downward spiraling process. President Suharto had to pay dearly for not addressing the problem straight 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 making 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 of restructuring the 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 been abating. In fact, statistics on maroeconomic indicators have shown a gloomier picture in terms of the GDP growth prospect, the inflation rate, the budget deficit, the food and other basic commodities situation. The rupiah has been strengthening somewhat, possibly due to some encouraging news about the 8 billion dollar loan for fast disbursement from the CGI recently. But, the bad news from Japan and its implication for Asia, and the still unclear government position about some social issues, seems to cause a lukewarm attitude of the market so far. Investors and creditors are kept saying that they still want to wait for the social and politics to return to stability first before they are willing to invest in or lend to Indonesia. They trust the long term potential, but wait for some time before resuming their activities in Indonesia. In other words, despite the good public reception on some statements or steps that President Habibie recently making, questions still being raised, if not on whether he is sincere, on whether he could deliver.

A BRIEF LOOK AT A SOMBER PICTURE

After a year of distress and crisis, the Indonesian economy at present has not seen the light yet. Statistics of economic indicators are difficult to hold on because of so many uncertainties. However, some available macroeconomic indicators show a somber economic picture which promise to get worse before getting better. The turmoil in the last twelve months has resulted in a drastic slide down of almost all economic activities. Some data released recently by the Central Bureau of Statistics showed that the economic contraction for the first semester of 1998, annualized, was a little over 12%. And for 1998 it will be more than 13%. The inflation rate for 1998 will be more than 80%, unemployment 17% and the number of population living below poverty line will increase from 22 million to 80 million. The rupiah has been depreciated by more than 80 % since July last year, or more than 20% since President Habibie took charge, while the budget deficit will be ballooning. The crisis has really been hitting the Indonesian economy so hard that, after a year, our economy has been turning from continued high growth with stabilizing tendency into a slump.

The picture of the Indonesian economy at present is not very clear, confusing for many, and frustrating for those who are interested in contributing to finding solution to the pertaining problems. Indonesia has been suffering from a problem which initially was clearly a currency or an exchange rate problem, but through time and contagious process, has become economic, social and political crisis. As I mentioned before, the crisis that the national economy has been confronting in the past year has become complicated that one may have difficulty in separating the causes from the consequences. However, it is crucial that we recognize the problems clearly before we can pursue a program to address the problems effectively.

AND SOME PROSPECTS FOR RECOVERY

To get the economy back to normal we have to be out from the crisis first. However, to be able to get out from the crisis we have to have a clear picture of the whole problems, 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 with a crisis originating from contagious process, time is the essence, the sooner the better. The sooner we recognize the problems, the sooner we come up with good programs, and the sooner we have a good implementation - and hopefully being help by a touch of luck - the better will the chance for success.

Granted that a promise for political reform could lead to some state of stability, 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 for no backsliding program implementation from the Government and more adaptable attitude from the Fund would be helpful
  • More consistent steps on the implementation of banking restructuring program, both for the insolvent, the weak and the healthy banks.
  • Consistent follow-up steps on solution to corporate debts and banks' debts, including trade financing and money line facility.
  • A fiscal and monetary stance which could support the restructuring programs without constraining stability.
  • Steps to revive export and tourism activities. At the time that foreign investors are still taking the 'wait and see attitude', campaigning for tourism does not have to wait.

These steps could be taken smoothly, provided that a 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 the supply problems, the foreign commitments through the CGI and others have to be consistently implemented. But, on the distribution problems, the government has to realize the seriousness of the damage of the distribution system due to the burning, looting and raping, particularly against the Chinese. The fact that so many ethnic Chinese fled the country, taking along their capital, has been very damaging to the distribution system, due to their prominent role in this business. Without some assurance about their safety from the government with our security forces, it seems to be unrealistic to expect them to come back and resuming their businesses. The government program to enhance the small businesses and cooperatives will take time, if it is implemented effectively. I do not see any problem to design a reservation scheme to create a better balance for 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 the pressing problems, but the market kept waiting to make any positive move. In my view, this actually means that somehow 'a turn around' still has to come before the market players - the buyers, investors, and creditors - are willing give positive responses 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. 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 marginal efficiency capital. However, it is difficult to define what does 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 the confidence is presence the market is not very demanding. However when it is lost, everything we do is not good enough, the market is extreme.

The turn around have to be produced by the government by showing the market how the government view the whole problems facing our country and a credible program to be implemented. This has to be done to get public support for the implementation of the program. The most important is to change the negative perception of the market - another 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.

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