The rupiah -- one year after its float<\/p>\n
This is the first of two articles based on an address given by
\nformer Bank Indonesia (BI) governor J. Soedradjad Djiwandono to a
\nluncheon organized by the Indonesia Australia Business Council in
\nJakarta on Aug. 11.<\/p>\n
JAKARTA: Repeated discussions have failed to uncover the cause
\nof the unprecedented depreciation in the value of the rupiah
\nagainst the U.S. dollar in a very short period of time, what its
\nreal equilibrium level should be, and its fate in the near
\nfuture.<\/p>\n
Most Indonesians want to see the rupiah strengthening, but it
\nis very difficult to determine what is now a feasible exchange
\nrate for the currency and how to bring this about.<\/p>\n
One cannot get to the heart of the problems that caused the
\ndramatic collapse in the rupiah without looking at them in a
\nwider social and economic context and with reference to the
\ncrisis which has engulfed Indonesia.<\/p>\n
By looking at how the crisis evolved, identifying its origins
\nand examining steps taken by the government to cope with it, a
\nbetter understanding of the problems afflicting the rupiah can be
\ngained, which in turn helps to shed some light on its future
\nprospects.<\/p>\n
Many have said the Asian crisis is unprecedented in its
\nseverity and magnitude. The impact of the crisis has been
\ndevastating to a point that it has even exceeded the expectations
\nof the most pessimistic observers. Indonesia, Thailand and South
\nKorea have suffered more than others, and without doubt it is
\nIndonesia from among these countries that has borne the brunt of
\nthe havoc wrecked by the crisis throughout the region.<\/p>\n
The manner in which certain events in the Indonesian economy
\nevolved into the economic crisis demonstrates that it has its
\norigins in an ordinary currency problem which arose when the
\nrupiah came under sudden pressure last July after the Thai baht
\nweakened and was subsequently floated early in the same month.
\nThe government's response and the market's reaction then
\ncompounded the problem and caused its effects to spread rapidly
\nthrough all sectors of the national economy before it finally
\nimpacted on politics.<\/p>\n
Chronologically, the crisis can be traced as follows.<\/p>\n
* It started with market pressure on the rupiah resulting from
\nthe contagious spread of a currency market imbalance in the
\nregion. At that time the exchange rate was allowed to float
\nwithin a certain range which the government would intervene to
\ndefend. Faced with currency market pressure, the government took
\nthe decision to widen the band in which the rupiah was allowed to
\nfluctuate from 8 percent to 12 percent on July 11, 1997, the same
\nday as the Philippine peso was floated.<\/p>\n
* The market reaction to this move differed from past reactions.
\nIn the five times between 1994 and 1997 that the government
\nwidened the intervention band, the rupiah appreciated in value.
\nHowever this time a rapid depreciation in the value of the rupiah
\nwas recorded and when it broke through the intervention band,
\nBank Indonesia intervened in the currency market to support it.<\/p>\n
* This failed to abate pressure on the currency and so it was
\nfloated on Aug. 14, 1997. Bank Indonesia intervened in both the
\nforward and spot market to support the exchange rate and the
\nmoney supply was tightened through monetary and fiscal means.<\/p>\n
* Despite BI's intervention in the market, the problems spread to
\ninclude the banking sector. As the problems continued, confidence
\nin the banking sector started to fail and a flight of capital to
\ninstitutions perceived to be safer began.<\/p>\n
The crisis of confidence worsened through a combination of the
\nweakening rupiah, a loss of confidence in the country's banks and
\na tiering of the interbank money market.<\/p>\n
* The effects of difficulties in the money market and the banking
\nsector gradually filtered into the real sector because commercial
\nbanks were forced to reduced lending which in turn resulted in a
\nsharp increase in interest rates on loans. The crisis in the
\nbanking sector then worsened further with the closure of 16
\ninsolvent banks. Thus from the initial currency shocks, through
\nto distress in the banking sector, Indonesia had finally fallen
\ninto the grip of a total economic crisis.<\/p>\n
The crisis then began to gnaw into the social fabric of the
\ncountry, affecting the national political and social landscape
\nthrough the outbreaks of unrest which followed the spread of the
\nrecession and through failing public confidence in the government
\nand the national leadership.<\/p>\n
The Indonesian crisis can therefore be traced back to an
\nexternal shock to the currency market which caused by the
\ncontagious effect of a change in market sentiment in the region.<\/p>\n
Evidence of the shift in market sentiment can be seen in the
\nrapid downgrading of sovereign ratings and the disappearance of
\nthe term \"Asian miracle\", to be quickly replaced by \"crisis\",
\n\"chaos\" and \"meltdown\".<\/p>\n
But most telling of all was the Institute of International
\nFinance's publication on capital flows for Thailand, Malaysia,
\nIndonesia, the Philippines and South Korea. These countries
\nenjoyed a US$93 billion capital inflow in 1996 which changed to a
\n$12 billion outflow in 1997.<\/p>\n
A World Bank report circulated at the recent Consultative
\nGroup on Indonesia (CGI) meeting in Paris said that Indonesia had
\na capital inflow of $10 billion in 1996\/1997 and a capital
\noutflow of $12 billion in 1997\/1998.<\/p>\n
When confronted with this, the Indonesian economy -- burdened
\nby an inefficient real sector, a high cost economy, crony
\ncapitalism and a weak banking and financial system -- was unable
\nto cope and the crisis therefore spread quickly to other sectors
\nof the economy.<\/p>\n
The crisis grew through the economy then, in a similar
\nfashion, spread contagiously into the nation's social and
\npolitical life, again aided by structural weaknesses in the
\nsystem which it was attacking -- this time not economic in
\nnature, but social and political.<\/p>\n
The government initially responded promptly to the currency
\nproblems, widening the central bank's intervention band in the
\nforeign exchange market on the same day as the Philippine peso
\nwas floated and within one week of Thailand's capitulation to
\ncurrency speculators.<\/p>\n
However, when the rupiah depreciated drastically after the
\nBank Indonesia intervention band was widened it became apparent
\nthat something very different from previous difficulties in the
\ncurrency market was unfolding.<\/p>\n
Foreign market players decided to shift investments out of the
\nregion after the frailty of the financial system was exposed by
\nthe currency market troubles.<\/p>\n
Faced with persistent pressure on the rupiah, BI intervened in
\nthe market, first by selling dollars on the forward market, and
\nlater by selling on the spot market.<\/p>\n
When these efforts failed to strengthen the rupiah, the
\ngovernment discarded the managed floating system for the rupiah
\nand cut it loose to let the market determine its value in the
\nmiddle of August 1997. This move was supported by a tightening of
\nmonetary policy and through fiscal measures. The banking sector
\nthen started to suffer, partly as a result of these stringent
\nsupportive measures and there were runs on a number of banks.<\/p>\n
Realizing that the problem had spread into the banking sector,
\nin early September 1997 the government launched a broad
\ninitiative aimed at coping with the crisis which included not
\nonly monetary and fiscal measures, but also steps to deregulate
\nthe real sector. This policy initiative can be seen as a
\nprecursor to the IMF reform program, which came later at the end
\nof October 1997.<\/p>\n
The first IMF-sponsored program of reform, agreed to in a
\nletter of intent submitted to the fund on Oct. 31, 1997,
\nconsisted of a package of policies for financial restructuring
\nand reform in the real sector which were to be supported by
\nprudent monetary and fiscal policy.<\/p>\n
The core of the program was a comprehensive strategy to deal
\nwith insolvent and weak banks and the financial infrastructure.
\nIt included measures to strengthen banking supervision and to
\novercome structural rigidities in the real sector of the economy.
\nThe program was intended to be a framework to restore confidence
\nand arrest the decline in the value of the rupiah. It was built
\naround three main areas.<\/p>\n
* A strong macroeconomic framework consisting of tight monetary
\npolicy and substantial fiscal measures to achieve an orderly
\nadjustment in the external current account.<\/p>\n
* A comprehensive strategy to restructure the financial sector,
\nincluding the closure of insolvent institutions.<\/p>\n
* A broad range of structural measures to improve governance.<\/p>\n
Initially, the program received a positive response from the
\nmarket, the external market in particular. The closure of 16
\ninsolvent banks and joint intervention in the currency market by
\nBI, the Monetary Authority of Singapore and the Bank of Japan
\nwere welcomed by the (external) market and resulted in a
\nstrengthening of the rupiah from Rp 3,900 to the dollar to Rp
\n3,200, where it temporarily stabilized.<\/p>\n
However the domestic reaction to the closure of the banks ran
\ncontrary to expectations. Ironically, a step taken to bring back
\nconfidence in the banking sector plunged it into further chaos
\nand resulted in a massive flight of capital out of their coffers.
\nMany banks lost their deposit base and the interbank money market
\nbecame compartmentalized. Since January 1998, letters of credit
\nissued by Indonesian banks have not been accepted abroad.<\/p>\n
The crisis can therefore be seen to evolve around three basic
\nissues -- the drastically weak rupiah rate; the loss of the
\ndeposit base and creditor's faith in the banking sector; and the
\ninability of the business sector to repay foreign debts.<\/p>\n
Window A: The Indonesian crisis can therefore be traced back to
\nan external shock to the currency market which caused by the
\ncontagious effect of a change in market sentiment in the region.<\/p>\n
Window B: However the domestic reaction to the closure of the banks
\nran contrary to expectations. Ironically, a step taken to bring
\nback confidence in the banking sector plunged it into further chaos
\nand resulted in a massive flight of capital out of their coffers.
\nMany banks lost their deposit base and the interbank money market
\nbecame compartmentalized. Since January 1998, letters of credit
\nissued by Indonesian banks have not been accepted abroad.<\/p>",
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