The rupiah -- one year after its float

This is the first of two articles based on an address given by former Bank Indonesia (BI) governor J. Soedradjad Djiwandono to a luncheon organized by the Indonesia Australia Business Council in Jakarta on Aug. 11.

JAKARTA: Repeated discussions have failed to uncover the cause of the unprecedented depreciation in the value of the rupiah against the U.S. dollar in a very short period of time, what its real equilibrium level should be, and its fate in the near future.

Most Indonesians want to see the rupiah strengthening, but it is very difficult to determine what is now a feasible exchange rate for the currency and how to bring this about.

One cannot get to the heart of the problems that caused the dramatic collapse in the rupiah without looking at them in a wider social and economic context and with reference to the crisis which has engulfed Indonesia.

By looking at how the crisis evolved, identifying its origins and examining steps taken by the government to cope with it, a better understanding of the problems afflicting the rupiah can be gained, which in turn helps to shed some light on its future prospects.

Many have said the Asian crisis is unprecedented in its severity and magnitude. The impact of the crisis has been devastating to a point that it has even exceeded the expectations of the most pessimistic observers. Indonesia, Thailand and South Korea have suffered more than others, and without doubt it is Indonesia from among these countries that has borne the brunt of the havoc wrecked by the crisis throughout the region.

The manner in which certain events in the Indonesian economy evolved into the economic crisis demonstrates that it has its origins in an ordinary currency problem which arose when the rupiah came under sudden pressure last July after the Thai baht weakened and was subsequently floated early in the same month. The government's response and the market's reaction then compounded the problem and caused its effects to spread rapidly through all sectors of the national economy before it finally impacted on politics.

Chronologically, the crisis can be traced as follows.

* It started with market pressure on the rupiah resulting from the contagious spread of a currency market imbalance in the region. At that time the exchange rate was allowed to float within a certain range which the government would intervene to defend. Faced with currency market pressure, the government took the decision to widen the band in which the rupiah was allowed to fluctuate from 8 percent to 12 percent on July 11, 1997, the same day as the Philippine peso was floated.

* The market reaction to this move differed from past reactions. In the five times between 1994 and 1997 that the government widened the intervention band, the rupiah appreciated in value. However this time a rapid depreciation in the value of the rupiah was recorded and when it broke through the intervention band, Bank Indonesia intervened in the currency market to support it.

* This failed to abate pressure on the currency and so it was floated on Aug. 14, 1997. Bank Indonesia intervened in both the forward and spot market to support the exchange rate and the money supply was tightened through monetary and fiscal means.

* Despite BI's intervention in the market, the problems spread to include the banking sector. As the problems continued, confidence in the banking sector started to fail and a flight of capital to institutions perceived to be safer began.

The crisis of confidence worsened through a combination of the weakening rupiah, a loss of confidence in the country's banks and a tiering of the interbank money market.

* The effects of difficulties in the money market and the banking sector gradually filtered into the real sector because commercial banks were forced to reduced lending which in turn resulted in a sharp increase in interest rates on loans. The crisis in the banking sector then worsened further with the closure of 16 insolvent banks. Thus from the initial currency shocks, through to distress in the banking sector, Indonesia had finally fallen into the grip of a total economic crisis.

The crisis then began to gnaw into the social fabric of the country, affecting the national political and social landscape through the outbreaks of unrest which followed the spread of the recession and through failing public confidence in the government and the national leadership.

The Indonesian crisis can therefore be traced back to an external shock to the currency market which caused by the contagious effect of a change in market sentiment in the region.

Evidence of the shift in market sentiment can be seen in the rapid downgrading of sovereign ratings and the disappearance of the term "Asian miracle", to be quickly replaced by "crisis", "chaos" and "meltdown".

But most telling of all was the Institute of International Finance's publication on capital flows for Thailand, Malaysia, Indonesia, the Philippines and South Korea. These countries enjoyed a US$93 billion capital inflow in 1996 which changed to a $12 billion outflow in 1997.

A World Bank report circulated at the recent Consultative Group on Indonesia (CGI) meeting in Paris said that Indonesia had a capital inflow of $10 billion in 1996/1997 and a capital outflow of $12 billion in 1997/1998.

When confronted with this, the Indonesian economy -- burdened by an inefficient real sector, a high cost economy, crony capitalism and a weak banking and financial system -- was unable to cope and the crisis therefore spread quickly to other sectors of the economy.

The crisis grew through the economy then, in a similar fashion, spread contagiously into the nation's social and political life, again aided by structural weaknesses in the system which it was attacking -- this time not economic in nature, but social and political.

The government initially responded promptly to the currency problems, widening the central bank's intervention band in the foreign exchange market on the same day as the Philippine peso was floated and within one week of Thailand's capitulation to currency speculators.

However, when the rupiah depreciated drastically after the Bank Indonesia intervention band was widened it became apparent that something very different from previous difficulties in the currency market was unfolding.

Foreign market players decided to shift investments out of the region after the frailty of the financial system was exposed by the currency market troubles.

Faced with persistent pressure on the rupiah, BI intervened in the market, first by selling dollars on the forward market, and later by selling on the spot market.

When these efforts failed to strengthen the rupiah, the government discarded the managed floating system for the rupiah and cut it loose to let the market determine its value in the middle of August 1997. This move was supported by a tightening of monetary policy and through fiscal measures. The banking sector then started to suffer, partly as a result of these stringent supportive measures and there were runs on a number of banks.

Realizing that the problem had spread into the banking sector, in early September 1997 the government launched a broad initiative aimed at coping with the crisis which included not only monetary and fiscal measures, but also steps to deregulate the real sector. This policy initiative can be seen as a precursor to the IMF reform program, which came later at the end of October 1997.

The first IMF-sponsored program of reform, agreed to in a letter of intent submitted to the fund on Oct. 31, 1997, consisted of a package of policies for financial restructuring and reform in the real sector which were to be supported by prudent monetary and fiscal policy.

The core of the program was a comprehensive strategy to deal with insolvent and weak banks and the financial infrastructure. It included measures to strengthen banking supervision and to overcome structural rigidities in the real sector of the economy. The program was intended to be a framework to restore confidence and arrest the decline in the value of the rupiah. It was built around three main areas.

* A strong macroeconomic framework consisting of tight monetary policy and substantial fiscal measures to achieve an orderly adjustment in the external current account.

* A comprehensive strategy to restructure the financial sector, including the closure of insolvent institutions.

* A broad range of structural measures to improve governance.

Initially, the program received a positive response from the market, the external market in particular. The closure of 16 insolvent banks and joint intervention in the currency market by BI, the Monetary Authority of Singapore and the Bank of Japan were welcomed by the (external) market and resulted in a strengthening of the rupiah from Rp 3,900 to the dollar to Rp 3,200, where it temporarily stabilized.

However the domestic reaction to the closure of the banks ran contrary to expectations. Ironically, a step taken to bring back confidence in the banking sector plunged it into further chaos and resulted in a massive flight of capital out of their coffers. Many banks lost their deposit base and the interbank money market became compartmentalized. Since January 1998, letters of credit issued by Indonesian banks have not been accepted abroad.

The crisis can therefore be seen to evolve around three basic issues -- the drastically weak rupiah rate; the loss of the deposit base and creditor's faith in the banking sector; and the inability of the business sector to repay foreign debts.

Window A: The Indonesian crisis can therefore be traced back to an external shock to the currency market which caused by the contagious effect of a change in market sentiment in the region.

Window B: However the domestic reaction to the closure of the banks ran contrary to expectations. Ironically, a step taken to bring back confidence in the banking sector plunged it into further chaos and resulted in a massive flight of capital out of their coffers. Many banks lost their deposit base and the interbank money market became compartmentalized. Since January 1998, letters of credit issued by Indonesian banks have not been accepted abroad.