|CENTRAL BANKING IN THE MIDST OF
The Case of Indonesia
by J. Soedradjad Djiwandono
Together with Thailand and South Korea, Indonesia have been implementing an IMF supported program of economic reform and financial restructuring for almost a year now. The issue of the IMF and sovereignty , what left for national government, as the main subject of this part of the seminar, is very relevant in the case of Indonesia. This is the topic of my discussion with reference to my experience in managing Bank Indonesia, the central bank of Indonesia, in coping with the crisis which has been going on since July last year.
I will address issues related to problems and challenges confronting the Indonesian economy and steps taken by the government to cope with them. Since the Indonesian government decided to ask for a stand- by arrangement from the IMF, issues related to the IMF role and conditionality are relevant. Since currency board arrangement was once proposed to be adopted, I would discuss the issues in the Indonesian context. I would discuss these issues as the governor who was in charge to manage the central bank until my discharge in February of this year.
@ Development Associate, HIID and former Governor of Bank Indonesia.
The Indonesian economic crisis
originated 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, which
hit Indonesia early July of last year. 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. For Indonesia,
the reversed capital flows of last fiscal year was
estimated to reach $22 billion, from inflows of $10
billion to outflows of $12 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.
The process of how the crisis developed in Indonesia could be described as follow :
Among the three countries which have asked the IMF to provide with stand -by loans, Indonesian case has been 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.
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.
TO COPE WITH 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.2 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 these efforts 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 :
2. 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.
TO BE LEARNED
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. The following points are lessons which we could learn from the crisis and steps in monetary and banking policy which could be implemented by the monetary and banking supervision authority.
On Central Banking
On Currency Boards
In Indonesia, the proposal for adopting currency board arrangement came out in February, when, out of nowhere President Suharto was attracted by a suggestion coming from Steve Henke, to adopt a currency board arrangement to strengthen rupiah. However, the Indonesian economy has been suffering from different problem of confidence. There are problems of confidence towards rupiah, the banking system and the ability of the private sector to pay debt, especially foreign debt (private sector foreign debt overhang). CBA could be effective provided certain requirements are fulfilled, namely an adequate foreign exchange reserves to support the money supply, a sound banking system, which has to be supported by sound financial infrastructure, including adequate regulation and banking supervision, legal protection and good governance plus transparency. These are simply not there yet to support a CBA to be implemented in Indonesia.
On IMF role and conditionality
Several points related to IMF role and the conditionality :
3 See, for example, Ronald
McKinnon, The Order of Economic Liberalization,
(Baltimore: The John Hopkins University Press,1991)