The Case of Indonesia

by J. Soedradjad Djiwandono @

A Presentation at a Seminar " Crisis and Transition: Southeast Asia, Southeast Europe, and the Global Economy" organised by Woodrow Wilson International Center for Scholars Asia Program, and East European Studies, Washington, DC, September 17-18, 1998.



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 :

  • 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. 1
  • 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.

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.



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 :

  • 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.


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.



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

  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, however, different condition may require a different sequence 3. The issue of central bank independence.
  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. 4
  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 5. 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.6
  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. However, 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.
  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.7
  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.

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 :

  • On the role of IMF in the macroeconomic management; from precautionary to stand-by arrangement
  • On the tight money policy and high rates of interest for exchange rate management at the cost of the real sector; recession and the social costs
  • On the capital flows and private debts and the issues of foreign exchange control and capital account liberalization.


3 See, for example, Ronald McKinnon, The Order of Economic Liberalization, (Baltimore: The John Hopkins University Press,1991)
4 See Jagdish Bhagwati, 'The Capital Myth' in Foreign Affairs, May/June 1998, pp. 7-13.
5 See, Andrew Sheng, The Crisis of Money in the 21st Century, City University of Hongkong Guest Lecture, 21 April, 1998.
6 See also, Stanley Fischer, Banking Soundness and the Role of the Fund, in Charles Enoch and John H. Green, eds., Banking Soundness…….p.23.
7 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.