Recent Issues in the Management of Macroeconomic Policies ... · PDF fileMacroeconomic Policy ... ten quoted as the indicators of sound ... ISSUES IN THE MANAGEMENT OF MACROECONOMIC

Recent Issues in the Management ofMacroeconomic Policies in Indonesia

Anwar Nasution

Anwar Nasution is Senior Deputy Governor, Bank Indonesia; Dean, Faculty of Economics;and Professor of Economics, University of Indonesia.

2 A STUDY OF FINANCIAL MARKETS

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Introduction

The currency and financial crisis in Thailand of

March-June 1997 spread rapidly to other Asian coun-

tries, including Indonesia. To defend its external re-

serve position, Bank Indonesia (BI), the central bank,

abandoned the exchange rate intervention band on

14 August 1997, and adopted a floating exchange

rate system. Since then, the exchange and interest

rates have been jumping wildly. The external value

of the rupiah has depreciated by over 80 percent

since July 1997, when it was trading at about Rp2,400

to the dollar. During the same period, the composite

stock price index at the Jakarta Stock Exchange

(JSX) plunged by more than 60 percent. A Pentasena

Securities analyst said that only 22 of 282 firms listed

on JSX were operating with sufficient cash flow by

end-1997. Bank deposit and loan interest rates have

soared to over 60 percent per annum. Meanwhile,

liquidity is very tight and depositors pay a stiff pen-

alty for withdrawing time deposits before their ma-

turity date.

A combination of factors caused the crisis:

• Excessive corporate short-term external borrow-

ings, which distorted product and financial mar-

ket structures, were not invested in ways that

would generate the export earnings necessary

for repayment.

• Financial sector reform was not accompanied

by strict implementation of rules and regula-

tions.

• A pervasive lack of confidence in the Govern-

ment, partly caused by the closure of 16 finan-

cially distressed banks in November 1997 and

by confusing Government policies, precipitated

a bank run, panic buying, and capital flight that

led to both internal and external liquidity crunch

and a sharp increase in velocity of money.

• Imports fell as foreign banks became reluctant

to roll over short-term debt and accept letters of

credit.

• The fear of further currency depreciation put

exchange and interest rates under even more

pressure.

• The Government’s decision to limit access to

foreign borrowings and to shift public sector de-

posits from (mainly State-owned) commercial

banks to the central bank squeezed liquidity.

• With banks suddenly illiquid, the risk of default

and bankruptcies also increased. BI adopted a

floating exchange rate system in mid-August

1997, suggesting that it had limited external re-

serves with which to defend the exchange rate.

The financial crisis occurred at an unfortunate

time. The long drought and massive forest fire in

1997-1998 seriously damaged the forestry and agri-

culture sectors. Crop production fell by 1.8 percent

and agricultural growth dropped to 0.6 percent in 1997.

At the same time, the country was devastated by the

fall in oil prices—to their lowest in 10 years—and

low demand for Indonesian exports (such as wood-

based products), which reduced foreign exchange

revenues. Meanwhile, economic difficulties and slow

growth have dried up capital inflows from Japan and

Korea.

Economic problems were compounded by politi-

cal uncertainty generated by the 1997 general elec-

tions and the March 1998 presidential election. An-

gered by rising prices and unemployment, mobs ri-

oted in a number of towns, forcing President Suharto,

who had ruled the country since 1966, to resign. But

political uncertainty remained, mainly because his

successor, Burhanuddin Jusuf Habibie, was a protégé

of Suharto, with no strong political base and a repu-

tation as a big spender.

The removal of President Suharto, however, ended

the uncertainty of economic policy. The present ad-

ministration is committed to implementing the Inter-

national Monetary Fund (IMF) program. This, along

with the depreciation of the dollar, raised the exter-

nal value of the rupiah from Rp11,550 in mid-Sep-

tember 1998 to Rp7,800 one month later. The stron-

3ISSUES IN THE MANAGEMENT OF MACROECONOMIC POLICIES IN INDONESIA

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ger rupiah helps reduce inflation and interest rates

and rehabilitate the banks and their customers.

The first part of this study reviews the economic

meltdown in Indonesia, its causes and impacts, and

the Government’s responses to it. The second ex-

amines precrisis macroeconomic developments. The

third discusses the banking crisis. The fourth deals

with policy responses to the capital inflows since the

early 1990s, analyzes the fiscal distress and stabili-

zation program, and forecasts the result of the re-

cent appreciation of the rupiah. Finally, the fifth sec-

tion presents the conclusion.

Macroeconomic PolicyThe currency crisis is the product of inconsistent fis-

cal and monetary policies in an exchange rate sys-

tem with an intervention band. The Government bud-

get deficit (hovering around 0.5-1 percent of gross

domestic product [GDP] in the five years before the

1997 crisis) was too small to check the rapid expan-

sion of private sector consumption and investment

expenditure. Lax implementation of banking rules and

regulations resulted in credit overexpansion. As will

be discussed later, some private sector expenditure

and bank credit were financed by short-term

unhedged external borrowings.

The exchange rate system has caused not only

real appreciation of the exchange rate, but also sub-

stantial bets when the intervention band was finally

abandoned on 14 August 1997. As the growing cur-

rent account deficit could not be financed by running

down external reserves, the Government had two

policy options to narrow or close the deficit: (i) cut

domestic absorption or (ii) depreciate the domestic

currency. The authorities opted to defend external

reserves by moving from the intervention band sys-

tem to a free float, which raised both interest and

exchange rates. As the banks had high bad-loan ra-

tios, the rising interest and exchange rate risks caused

many bankruptcies and hurt the financial system and

economic growth, especially since Indonesian com-

panies followed a high debt/equity financing strategy

and heavily relied on external debt.

Indonesia’s economic fundamentals began to

weaken and the international environment to change

in 1995. Massive capital inflows and the shift in their

composition toward short-term private sector capital

since the early 1990s caused bouts of domestic eco-

nomic overheating as rapid economic growth was

accompanied by rising inflation and interest rates and

current account deficits (Table 1). Low inflation, high

GDP growth, and high growth of nonoil exports, of-

ten quoted as the indicators of sound economic fun-

damentals, were largely artificial. The Government

subsidized State-vended products at great cost and

thereby kept the inflation rate below 10 percent per

annum in 1990-1996.

High GDP growth was mostly associated with the

“bubble” industries, including construction, public utili-

ties, and services in the nontraded sector of the

economy (Table 2). Moreover, most nonoil export

growth was in electronics, sport shoes, and textiles

and garments (Table 3), which utilized very little do-

mestic inputs and were associated with firms from

Japan; Korea; and Taipei,China—economies with

strong currencies. In contrast, domestically owned

firms that relied heavily on domestic inputs fared poorly.

Part of the problem was that palm oil and wood-based

exports were subject to quotas. Revenue from oil ex-

ports also declined as oil prices fell to as low as $12.14

per barrel in March 1998, their lowest in 10 years.

The IMF program signed on 24 June 1998, the

fourth since October 1997, predicted that economic

growth would fall by at least 10 percent in 1998 and

that the exchange rate would hover around Rp10,000

to the dollar by the end of the same year. The budget

deficit was forecasted to reach 8.5 percent of GDP

in FY1999. Despite a large subsidy (6 percent of

GDP) to control prices of State-vended products, the

inflation rate was expected to rise 80-100 percent in

1998. Rising unemployment and inflation brought the

number of people below the poverty line from 22.5


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million (11.3 percent of the total population) in 1996

to 79.4 million (39.1 percent) in 1998 (The Jakarta

Post, 3 July 1998). Poverty is more pronounced in

rural areas and on Java island, where the agriculture

sector relies heavily on rice and poultry. Rice fields

require plenty of water, and poultry need expensive

imported feeds. Over 45 percent of the rural popula-

tion, or 56.8 million people, live below the poverty

line. Of Indonesia’s more than 200 million people,

two thirds live on Java.

The current account balance is expected to im-

prove somewhat, but mainly because of reduced

imports (due to expenditure cut and rupiah deprecia-

tion) rather than increased exports. The agreements

reached in Frankfurt in June 1998, regarding private

sector external debt, and in Paris on 23 September

Table 1: Selected Key Economic Indicators, 1990–1999 ( % of GDP, unless otherwise indicated)

na = not available.( ) = negative values are enclosed in parentheses.a Up to second quarter of 1999.b Compared to second quarter of 1998.Sources: IMF, International Financial Statistics, various issues; World Bank, 1996; Bank Indonesia, Indonesian Financial Statistics, various issues; Central Board of Statistics, 1999.

Item 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999a

Internal StabilityReal GDP (% growth rate) 9.0 8.9 7.2 7.3 7.5 8.1 8.0 4.6 (13.6) (4.1)b

Consumption 63.7 63.9 62.0 67.5 65.1 69.1 70.3 70.4 78.3 naPrivate 53.9 54.0 52.2 58.5 56.5 61.0 62.7 63.1 70.9 na

Government 9.8 9.8 9.8 9.0 8.6 8.0 7.6 7.3 7.4 na

National Saving 27.5 26.9 26.9 27.0 28.4 28.0 29.3 28.0 na naPrivate 19.1 19.8 20.5 20.4 22.0 22.4 23.0 17.2 na na

Public 8.4 7.1 6.4 6.6 6.4 5.6 6.3 10.8 8.0 na

Investment 30.1 29.4 28.7 28.3 30.3 31.3 32.7 32.0 20.9 naPrivate 23.5 21.7 20.9 20.9 24.0 25.8 27.4 na na na

Public 6.6 7.7 7.8 7.4 6.3 5.5 5.3 na na na

Inflation (CPI, %) 9.5 9.5 4.9 9.8 9.2 8.6 6.5 11.6 77.6 2.7Fiscal Balance 0.4 0.4 (0.4) (0.6) 0.1 0.8 0.2 (0.2) na na

External StabilityCurrent Account Balance (2.8) (3.7) (2.2) (1.6) (1.7) (3.6) (3.7) (2.7) 0.1 9.9Real Effective Exchange Rate (1997=100) 95.1 93.2 90.8 85.6 82.5 80.1 78.0 100.0 315.8 114.6

Nominal Exchange Rate/CPI (1997=100) 111.3 107.7 104.2 97.7 93.2 88.6 85.5 100.0 238.1 343.4

Net Capital Inflows 4.9 5.0 3.8 1.7 2.0 4.0 5.4 (1.1) (45.8) (26.5)Of which:

Net Direct Investment 1.0 1.3 1.4 1.0 0.8 1.9 2.5 2.1 (0.7) (1.2)

Net Portfolio Investment (0.1) 0.0 (0.1) 1.1 2.2 2.0 2.2 (1.2) (14.4) (8.2)Other Capital 3.3 3.6 3.5 1.4 (0.9) 1.2 0.1 (0.2) (26.1) (17.2)

Net Error and Omissions 0.7 0.1 (1.0) (1.9) (0.1) (1.1) 0.6 (1.8) (4.6) 0.1

Net Resource Transfer/GDP (1997=100) (100.1) (86.1) (535.6) (749.0) (309.7) 396.3 198.5 100.0 190.3 naReserves (in months of imports) 4.7 4.8 5.0 5.2 5.0 4.4 5.1 4.4 7.3 na

Ratio of M2 to Reserves (%) 596.8 539.0 552.6 602.3 643.4 690.3 638.6 419.9 407.5 322.7

Total External Debt 65.9 68.4 69.0 56.7 55.5 54.8 49.3 101.4 127.1 naTotal External Debt (% of Exports of

Goods and Services) 222.0 236.9 221.8 211.9 197.4 197.4 188.7 255.0 232.2 na

Short-term Debt ($ billion) 11.1 14.3 18.1 18.8 21.1 27.6 35.0 37.0 41.0 naShort-term Debt (% of Total External Debt) 15.9 17.9 20.5 21.0 19.6 22.2 27.1 27.2 27.2 na

Debt-Service Ratio (% of Exports of

Goods and Services) 30.9 32.0 33.0 33.6 32.6 30.3 35.9 40.5 58.6 51.6Exports of Goods & Services 25.1 28.1 30.2 26.8 26.9 27.2 27.1 27.5 11.5 na

Exports of Goods ( % growth rate) 15.9 13.5 16.6 8.4 8.8 13.4 9.7 7.5 15.4 (18.8)b

Imports (1997 = 100) 112.0 123.4 131.7 134.6 136.9 165.0 175.4 100.0 24.9 na


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1998, to reschedule the public external debt, are an-

ticipated to ease the short-term pressure on external

debt repayment. A combination of the yen’s depre-

ciation against the dollar since 1995 and the still-weak

banking system in Japan slowed down Japanese di-

rect investment to Indonesia. Capital flows from

newly industrializing economies such as Korea also

dried up due to slow export growth and financial

strain. The rise in US interest rates and investment

returns further reduced capital inflows as they made

investment in emerging countries, including Indone-

sia, less attractive.

Exchange Rate MovementsThe exchange rate is the single most important rela-

tive price in the economy. In economies more open

than Indonesia, monetary transmission operates

through exchange rate effects on net exports and

interest rate effects on financial portfolio. The ex-

change rate policy in Indonesia, jointly with other

Table 2: Gross Domestic Product Share and Growth by Industrial Origin (%)

na = not available.( ) = negative values are enclosed in parentheses.a At 1983 constant market prices for 1985–1993, and 1993 constant market prices for 1994–1999.b Preliminary data; growth rates apply to January–June 1999 relative to the same period in 1998.c Includes nonfood crops, forestry and fishery, mining and quarrying, and manufacturing industries.d Covers farm food crops; livestock and products; electricity, gas and water supply; construction; and trade, hotel and restaurant.Source: Central Bureau of Statistics, Economic Indicators, various issues.

Share Rate of Growtha

Item 1985 1995 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999b

Gross Domestic Product 100.0100.0 7.2 7.0 6.5 6.5 7.6 8.1 8.0 4.6 (13.2) (4.1)

Gross Domestic Product (Nonpetroleum) 78.7 91.3 7.6 6.5 8.4 7.8 8.1 9.1 8.3 5.3 (14.3) (4.4)

1. Agriculture, Livestock, Forestry and Fishery 22.6 16.1 2.0 1.6 6.7 1.4 0.9 3.8 3.2 0.7 0.8 5.1

1.1. Farm Food Crops 14.0 8.6 0.5 (0.5) 7.7 (1.2) (2.1) 4.6 2.4 (2.7) 1.9 8.1

1.2. Nonfood Crops 3.6 2.6 4.9 5.4 4.8 5.8 5.1 4.7 4.2 1.2 2.8 6.9

1.3. Livestock and Products 2.4 1.8 3.7 6.0 7.9 5.6 4.0 4.2 6.1 4.9 (7.1) (0.4)

1.4. Forestry 1.0 1.6 3.0 0.0 (2.2) 1.7 0.5 0.0 1.3 8.0 (1.8) (4.5)

1.5. Fishery 1.6 1.6 5.0 5.2 5.8 5.7 8.8 1.9 4.6 5.8 4.1 2.0

2. Mining and Quarrying 18.2 9.3 5.2 10.2 (1.9) 2.2 5.6 6.7 5.8 1.7 (3.1) 0.1

2.1. Crude Petroleum and Natural Gas 17.1 6.2 4.2 9.3 (4.5) (0.3) 2.6 0.0 1.4 (0.6) (2.1) (4.5)

2.2. Other Mining and Quarrying 1.1 3.1 18.0 20.1 24.0 20.8 13.9 23.5 14.6 5.2 (4.7) 8.5

3. Manufacturing Industries 15.8 23.9 12.5 10.1 9.7 9.3 12.5 10.7 11.7 6.4 (11.9) (2.3)

3.1. Nonoil and Gas Manufacturing 11.5 21.3 13.0 10.9 11.0 11.6 13.5 13.0 11.7 7.4 (13.4) 8.2

3.2. Oil/Gas Industry 4.3 2.5 11.0 7.4 5.3 1.3 5.6 -5.4 11.1 (2.0) 1.6 (3.7)

4. Electricity, Gas and Water Supply 0.4 1.1 17.9 16.1 10.1 10.1 12.5 15.5 13.2 12.3 1.9 0.2

5. Construction 5.3 7.6 13.5 11.3 10.8 12.1 14.9 12.9 12.8 6.4 (40.5) (7.2)

6. Trade, Hotel and Restaurant 14.6 16.7 7.1 5.4 7.3 8.8 7.6 7.7 8.2 5.8 (18.0) (13.3)

6.1. Wholesale and Retail Trade 12.2 13.4 6.8 5.1 7.4 9.0 6.8 7.7 8.2 5.9 (18.5) (15.2)

6.2. Hotels and Restaurants 2.3 3.3 8.7 7.0 7.2 7.7 11.1 7.9 8.2 3.8 (16.3) (5.8)

7. Transportation and Communication 5.3 7.2 9.6 7.9 10.0 9.9 8.3 9.4 7.8 8.3 (15.1) (10.3)

7.1. Transportation 4.7 6.0 8.6 7.3 10.0 8.9 6.5 7.3 6.4 6.4 (19.9) (15.4)

7.2. Communication 0.5 1.2 16.9 12.3 10.0 16.4 20.4 21.1 14.5 17.4 4.8 7.5

8. Financial, Ownership and Business 6.4 9.0 10.1 9.7 9.8 10.3 10.2 11.2 8.8 6.5 (26.6) (16.5)

8.1. Banking and Other Financial Intermediaries 3.5 4.7 14.1 13.1 13.0 13.0 13.8 13.9 9.6 5.3 (34.0) (22.2)

8.2. Building Rental 2.9 2.8 4.2 4.0 4.2 5.0 4.0 5.5 5.8 5.0 (19.9) (11.9)

8.3. Business Services na 1.4 na na na na 12.0 14.2 12.1 8.5 (16.7) (10.8)

9. Services 11.3 9.2 4.7 3.7 4.3 4.3 2.8 3.3 3.4 2.8 (3.2) 3.1

9.1. Public Administration and Defense 7.6 6.0 4.6 3.1 3.0 2.0 1.3 1.3 1.3 1.2 (7.3) 1.9

9.2. Private Services 3.7 3.2 5.0 5.2 7.3 8.9 5.8 7.2 7.4 5.7 3.7 4.9

Traded Sectorc 40.2 38.9 8.5 9.3 4.5 6.2 9.5 8.5 9.1 5.2 (8.4) (1.2)

Nontraded Sectord 59.8 61.1 6.4 5.3 7.8 6.7 6.5 7.9 7.3 4.5 (16.6) (6.0)


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policies, was traditionally used to remove distortions

in the domestic economy and to help safeguard in-

ternational competitiveness.1 Until recently, the au-

thorities avoided the use of prolonged nominal and

real exchange rate overvaluation as a principal in-

strument for generating fiscal revenues and curbing

domestic inflation and interest rates.

To offset the “Dutch disease” effect of the oil

boom, the authorities (i) devalued the rupiah by 50

percent against the dollar in November 1978, (ii) re-

placed the dollar as external anchor with an undis-

closed basket of major currencies, and (iii) adopted

a managed floating exchange rate system. The

weight of the dollar in the currency basket, however,

remained substantial. The rupiah was further deval-

ued by 40 percent in June 1983 and by 31 percent in

September 1986. Normally, the authorities targeted

nominal depreciation of the rupiah against the dollar

Table 3: Exports by Commodity Group

( ) = negative values are enclosed in parentheses.a As of the first quarter of 1999; growth rates pertain to the first quarter of 1999 relative to the same period in 1998.b Includes processed wood, paper, and paper products.Source: Central Bureau of Statistics, Economic Indicators, various issues.

Commodity Group 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999a

Value ($ billion)

Agriculture 2.08 2.28 2.21 2.64 2.82 2.89 2.91 3.13 3.65 0.66

Industrial Products 11.88 15.07 19.61 22.94 25.70 29.33 32.12 34.99 34.59 6.95

Of which:

Forestry-based Productsb

3.48 3.87 4.53 6.01 5.86 6.00 6.09 6.24 5.85 1.25

Garments and Textile 2.93 4.08 6.06 6.18 5.80 6.20 6.55 5.27 6.53 1.37

Electronics 0.29 0.67 1.10 1.64 0.72 0.92 1.41 1.37 1.49 0.33

Mining and Mineral Products 0.64 0.89 1.45 1.46 1.80 2.69 3.02 3.11 2.70 0.67

Other Sectors 0.01 0.01 0.02 0.03 0.04 0.05 0.04 0.60 0.02 0.05

Total Nonoil Exports 14.60 18.25 23.30 27.08 30.36 34.95 38.09 41.82 40.96 8.33

Oil and Gas Exports 11.07 10.89 10.67 9.75 9.69 10.46 11.72 11.62 7.87 1.87

Total Exports 25.68 29.14 33.97 36.82 40.05 45.42 49.81 53.44 48.85 10.17

% of total exports

Agriculture 8.1 7.8 6.5 7.2 7.0 6.4 5.8 5.9 7.5 6.5

Industrial Products 46.3 51.7 57.7 62.3 64.2 64.6 64.5 65.5 70.8 68.3


13.6 13.3 13.3 16.3 14.6 13.2 12.2 11.7 12.0 12.3

Garments and Textile 11.4 14.0 17.8 16.8 14.5 13.7 13.2 9.9 13.4 13.5

Electronics 1.1 2.3 3.2 4.4 1.8 2.0 2.8 2.6 3.1 3.3

Mining and Mineral Products 2.5 3.1 4.3 4.0 4.5 5.9 6.1 5.8 5.5 6.6

Other Sectors 0.0 0.0 0.1 0.1 0.1 0.1 0.1 1.1 0.0 0.5

Total Nonoil Exports 56.9 62.6 68.6 73.5 75.8 77.0 76.5 78.3 83.8 81.9

Oil and Gas Exports 43.1 37.4 31.4 26.5 24.2 23.0 23.5 21.7 16.1 18.4

Total Exports 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Annual growth (%)

Agriculture 7.2 9.5 (3.1) 19.5 6.6 2.5 0.8 7.5 16.6 (17.8)

Industrial Products 7.7 26.8 30.2 17.0 12.0 14.1 9.5 8.9 (1.1) (21.1)


7.9 11.1 17.0 32.7 (2.4) 2.4 1.4 2.5 (6.3) 0.5

Garments and Textile 46.3 39.1 48.7 2.0 (6.2) 7.0 5.6 (19.6) 24.0 (12.6)

Electronics 50.5 133.9 64.0 49.2 (56.2) 28.5 53.0 (2.9) 8.8 0.8

Mining and Mineral Products 26.4 39.8 63.4 0.8 23.0 49.5 12.2 2.9 (13.2) 9.4

Other Sectors 10.3 35.9 108.0 38.1 54.4 19.2 (22.6) 1,574.4 (96.7) (32.4)

Total Nonoil Exports 8.3 24.9 27.7 16.2 12.1 15.1 9.0 9.8 (2.1) (19.0)

Oil and Gas Exports 27.5 (1.6) (2.1) (8.7) (0.5) 8.0 12.0 (0.8) (32.3) (17.8)

Total Exports 15.9 13.5 16.6 8.4 8.8 13.4 9.7 7.3 (8.6) (18.8)


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at 3-5 percent per annum. BI intervenes in the for-

eign exchange market by buying and selling the ru-

piah in an “intervention band” around the central rate.

Provided that the system is supported by other poli-

cies, the policy to stabilize the real exchange rate

helps avoid major macroeconomic crises even in an

inhospitable world economic environment.

Before shifting to the present flexible exchange

rate regime, BI had tried to defend the rupiah from

speculative attacks by widening the intervention band

in July 1997 (Figure 1), selling foreign exchange both

in forward and spot markets, and sterilization. In

theory, such exchange rate flexibility introduces un-

certainty that may well discourage part of the purely

speculative capital flows and allows the monetary

authorities a high degree of freedom to exercise control

over monetary aggregates. To support these policies,

the authorities also introduced a wide array of tight

monetary policies along with administrative measures

to limit external borrowings of commercial banks and

discourage short-term capital inflows, while maintain-

ing open access to the economy for long-term capital,

particularly foreign direct investment (Appendix). As

the authorities allow a temporary slight appreciation

of the rupiah, the policy should also reduce the need to

sterilize the surge in capital inflows.

BI finally had to abandon the moving band system

it adopted in 1992 in order to defend its foreign ex-

change reserve position, partly because the authori-

ties gave no clear signal that would restore public

confidence, prevent capital flight, and restore access

to the international money market. Until recently, the

Government had no clear program to solve the pri-

vate and public sectors’ external debt and banking

crises and no measures to promote growth by im-

proving economic efficiency and boosting nonoil ex-

ports.

The floating exchange rate system is the most flex-

ible and realistic for a big country such as Indonesia,

whose nontraded sector accounts for a large part of

its economy. The main objection to the currency board

system proposed to President Suharto by a US econo-

mist was that the only responsibility of the monetary

authorities would be to peg the external value of the

rupiah to an international currency, thus constraining

monetary policy to operate according to the gold stan-

dard. Money supply would contract in response to a

deficit in the balance of payments, which is caused

by a reduction in external reserves due to the fall in

oil exports, rising capital flight, and the increasing

burden of external debt repayments. It would also

require an adjustment program to suppress domestic

expenditures and to encourage nonoil exports. The

price of traded goods would have to increase rela-

tive to nontraded goods. These policies would have

traumatic and painful consequences in terms of both

unemployment and lost output. The alternative mea-

sure would be a combination of a devaluation of the

pegged exchange rate and a fall in domestic prices

brought about by a domestic recession.

In a floating exchange rate system, the domestic

currency’s depreciation can be used to adjust infla-

tion and interest rates. Inflation has been kept down

partly by Government’s policy to (i) run a “budget

surplus” or narrow down the budget deficit, (ii) sub-

sidize prices of State-vended products,2 and (iii) pur-

sue more vigorous trade liberalization. Trade policy

reform and productivity gains generated by the

economy-wide reform help relax the supply constraint

and check inflationary pressures. To control interest

Figure 1: Rupiah Exchange Rate and its InterventionBands, November 1995–August 1997

Sources: Bank Indonesia, Indonesian Financial Statistics, various issues; Universityof British Columbia Data Base.

Rp/$


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rates, the authorities had until recently adopted a

complex system of credit ceilings and directly con-

trolled allocation of banks’ credit as well as deposit

and lending rates. The selective credit policy helps

support the authorities’ allocation of resources, in-

cluding to projects favored by the remaining import-

substitution industrialization policy and the executing

firms.

Figure 2 shows a steady appreciation of the ef-

fective exchange rate of the rupiah in 1990-1996,

indicating a slight change in the Government’s ex-

change rate policy. The rupiah’s appreciation is also

due to the rising value of its main external anchor,

the US dollar, vis-a-vis the yen. This helped reduce

inflation and interest rates in 1996. In general, how-

ever, currency appreciation (i) erodes external com-

petitiveness; (ii) distorts saving and investment deci-

sions; and (iii) squanders scarce savings on unpro-

ductive projects, impeding the efficiency of the

economy at the micro level. The decline in inflation,

on the other hand, helps stabilize the rupiah.

Widening Current Account DeficitMaintained at below 2 percent of annual GDP in

1993 and 1994, the current account deficit rose to

3.6 percent in 1995 and 3.7 percent in 1996. Its dete-

rioration reflected not only higher investment, but also

an increase in overall investment from 30.1 to 32.7

percent of GDP in 1990-1996 (Table 1). One culprit

was the banking system, which converted part of

the increased liquidity into loans to finance invest-

ment, including those in the land-based industry (ho-

tel and tourist resorts, amusement and industrial parks,

real estate, commercial buildings, and shopping malls),

excessive infrastructure, and other nontradables.

Most of the private debt was directly borrowed from

foreign lenders and only a small fraction intermedi-

ated through the banking system.

Part of the capital inflows was probably used to

finance consumption expenditures, as shown by a

slight decline in the savings rate in the national ac-

count data. The number of credit cards issued and

volume of transactions using them also increased

rapidly. In FY1997, 1.6 million credit cards were in

use, having grown by nearly 30 percent, compared

to 28 percent in the previous year. In the same year,

the value of transactions using credit cards amounted

to Rp4.7 trillion, an increase of over 35 percent, com-

pared to 22 percent in 1996. Seventeen banks and

84 finance companies (with 40,000 merchant outlets

throughout the country) were licensed to conduct

credit card business.

Before the crisis, the authorities adopted two sound

fiscal measures to reduce the burden of external debt

repayment:

• Using the proceeds from privatization of State-

owned enterprises to retire expensive external

debt, which carries interest rates exceeding 10

percent per annum. Since FY1995, the Govern-

ment has repaid $1.5 billion, reducing the amount

of outstanding public debt by 2 percent.

• Introducing an expenditure-reducing policy, par-

ticularly measures to restrain public investment

demand and consumption.

Traditionally, cutting public expenditures is meant

to protect activities likely to produce high rates of

return and crucial for long-term growth, such as

investment in essential economic infrastructure

projects and in human resource development. As

public expenditures are to be spent mainly on such

nontraded goods, the structure of the public budget

cut also helps avoid an appreciation of the real ex-

change rate (Reisen 1996). The authorities, how-

Figure 2: Real Effective Exchange Rate Index,January 1990–May 1998 (1990 = 100)

Source: JP Morgan, Emerging Markets Data Watch, various issues.


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ever, protected investment in “strategic” industries,

the national car program, and excessive infrastruc-

ture projects, all of which require scarce foreign

exchange, skilled manpower, and protection from

imports.

The Government has also suffered a budget defi-

cit. However, a combination of greater tax effort,

tightening of fiscal policy, and improvement in the

operations of State-owned enterprises has reduced

the deficit and increased public sector savings. While

formally maintaining the “balanced budget principle,”

the Government has been running an annual budget

surplus of 0.2-0.8 percent of GDP since FY1994.3

Evidence suggests that the Ricardian equivalence

issue—which points to the possibility that the in-

crease in public savings will be offset by a decline

in private savings—has been relatively limited in

the Association of Southeast Asian Nations

(ASEAN) region, including Indonesia (Faruqee and

Husain 1995). The increase in public savings im-

mediately raised national savings, and thus helped

reduce inflation and interest rates and the current

deficit. Lower differential between domestic and

foreign interest rates slowed down capital inflow.

As a result, the widening of the tax base, removal

of egregious marginal tax rates, and significant im-

provements in the efficiency of tax administration

and operations of public companies have greatly

contributed to enhancing fiscal flexibility, stabilizing

domestic aggregate demand, and improving exter-

nal competitiveness.

The budget “surplus,” (actually, the excess of bor-

rowing fund), however, was inadequate to counter

the rapid expansion of off-budget expenditures and

Government-sponsored projects. There is no infor-

mation on the off-budget expenditures, but the list of

projects financed by it—including the aircraft and

national car industries4—rapidly expanded. Capital

inflows into this highly protected sector generated

welfare losses because, aside from producing nega-

tive value-added at international prices, they also re-

moved resources in the form of repatriated profits.

Fiscal position became more difficult because of the

revenue losses stemming from the introduction of

tax incentives for the national car program and other

pioneer projects owned by politically well-connected

business groups. Tax base was further eroded with

the grant of tax-deductible status for individual con-

tributions to poverty alleviation initiatives, such as

Takesra, headed by the former President.

Stock of External DebtMainly because of the surge in private sector direct

borrowings, Indonesia’s external debt shot up from

$66.9 billion in 1990 to $138 billion in March 1998

(Table 4), a level alarming by world standards. The

World Bank considers a debt/gross-national-product

(GNP) ratio of more than 80 percent as high risk and

a total debt-service/export ratio of 18 percent as the

“warning” threshold. The country’s external debt in

March 1998 was around 215 percent of export value

and about 160 percent of annual GDP. The debt ser-

vice ratio ranged from 30 to 34 percent and the in-

terest payment alone amounted to 12 percent of to-

tal exports in 1990-1996.

Table 4: External Debt by Debtor, as of March 1998($ billion)

Debtor Amount

Public Sector 65.56

Government 54.39

State-owned Enterprises 11.18

State Banks 5.61

Corporations 5.57

Private Sector 72.46

Private Banks 8.00

Nonbank Corporations 64.46

Total External Debt 138.02

Memo Items

Debt owed by:

Corporationsa 69.91

Bank Credit 64.48

Domestic Securities 5.43

Banks 13.61

Interbank Linesb 12.83

Domestic Securities 0.78

a Includes State enterprises’ debt.b Includes trade credits of about $4 billion.Source: Bank Indonesia.


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About 52 percent of the external debt in March

1998 ($72.5 billion) was owed by the private sector

and nearly 90 percent of it was received by non-

bank corporate entities. The average maturity of

the external debt is approximately 1.5 years (J.P.

Morgan, Global Data Watch, 16 January 1998:70).

In addition, short-term external debt denominated

in local currency amounted to $15 billion. Since the

late 1960s, the external borrowing strategy of the

public sector has been to maximize the inflow of

concessionary development aid from its nonsocialist

Western and Asian creditors. The “oil boom” of

the 1970s did not change this strategy. Together

with the resulting rise in real income, the oil boom

only shifted the country’s position to a less conces-

sional aid package. When it encountered rising debt

repayments following the currency realignment in

1986-1996, Indonesia turned to its creditors, par-

ticularly the Japanese.

Inflation RatesFigure 3 depicts the rapid increase in inflation rates

since the beginning of the economic crisis in August

1997, due to a combination of five factors:

• accelerated growth of money supply, which was

partly used to finance the budget deficit;

• erosion of public confidence in the Government’s

economic management and fear of banking in-

solvency that encouraged advance purchases of

consumer goods;

• depreciation of the rupiah, which raised prices

of imported goods;

• shortage of merchandise supply, including food,

because of import reduction and harvest failure;

and

• adjustment of prices of State-vended products.5

The efficiency and productivity gains from the

structural reforms have not been powerful enough

to check upward inflationary pressures. Loss of public

confidence in Government economic policy raised

velocity of money, as shown by the bank run, panic

buying, and flight of currency.

The role of money supply growth and confidence

can be distinguished from the long-run equation of

the quantity theory:

MV = PY (1)

where: M = stock of money supply,

V = income velocity of money,

P = general price level, and

Y = the level of real output.

By simple mathematical manipulation, identity (1)

can be rewritten in the following form:

DP/P = DM/M + DV/V - DY/Y (2)

Equation (2) indicates that inflation increases un-

der the following conditions: (i) rapid growth of money

supply (DM/M), (ii) rapidly rising income velocity of

money (DV/V), and (iii) low growth of real GDP

(DY/Y). When inflation is high, monetary factors

(M and V) are the most important in determining the

course of a stabilization program. The rate of growth

of real output affects fiscal deficit more than the

demand for money.

The Banking CrisisIndicators of banking system fragility are presented

in Table 5. In terms of total assets and bureaucracy,

the system is the core of the financial sector in Indo-

nesia (Nasution 1996). It has been the main source

of external financing for the corporate sector, which

traditionally adopts a financing strategy with high

debt/equity ratio. As a result, banking troubles have

precipitated a collapse in trade and production and

Figure 3: Monthly Inflation Rate, January 1996–August 1998 (percentage change ofCPI over previous month)

Source: Central Bureau of Statistics, various issues.

J F M A M J J A S O N D J F M A M J J A S O N D J F M A M J J A-2

0

2

4

6

8

10

12

14

1996 1997 1998

Percent

11IS

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EN

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RO

EC

ON

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IC P

OLIC

IES

IN IN

DO

NE

SIA

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Table 5: Banking Sector Indicators, 1985–1999

GDPGR = GDP Growth Rate, IPGR = Industrial Production Growth Rate, LGR = Loan Growth Rate, NFL = Net Foreign Liabilities, TBL = Total Bank Liabilities.na = not available, ( ) = negative values are enclosed in parentheses.a Data as of June 1999.b Including 12 banks taken over by Indonesian Bank Restructuring Agency (IBRA) as of June 1999.c Ratio of M2 to Reserve Money.dAs percentage of total loan outstanding of commercial banks. Nonperforming loan data tend to be underestimated. The decline of nonperforming loans to 8.8 percent of total credit in 1996 was mainly due to the write-off of bad loans at State commercial

banks and private ‘nonforeign exchange’ banks. As of end-March 1998, bank nonperforming loans reached over 70 percent of total loans for several banks.Sources: IMF, International Financial Statistics, various issues; Bank Indonesia, Annual Report, various issues.

Item 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999a

Number of Banks 114 110 109 108 145 171 192 208 234 240 240 239 222 222 167

Private Banks 69 65 64 63 88 109 129 144 161 166 165 164 144 130 80

State-owned Banksb 5 5 5 5 5 7 7 7 7 7 7 7 7 7 19

Foreign Banks and Joint Venture Banks 11 11 11 11 23 28 29 30 39 40 41 41 44 58 41

Regional Development Banks 29 29 29 29 29 27 27 27 27 27 27 27 27 27 27

Loan to Deposit Ratio (%) 102.9 96.3 101.9 105.7 112.6 118.2 130.7 129.3 132.4 134.9 137.7 131.0 123.7 129.2 80.7

LGR Minus GDPGR (%) 14.7 19.8 8.8 23.1 31.2 48.1 (9.9) 7.7 6.9 5.7 4.0 4.7 12.1 45.5 (42.6)

LGR Minus IPGR (%) 29.0 20.8 35.9 34.4 44.2 61.4 9.0 25.9 22.4 16.0 23.1 22.5 16.2 45.1 na

NFL to TBL Ratio(%) (20.0) (23.6) (18.2) (14.1) (10.6) 0.9 0.7 2.2 4.9 5.8 3.8 2.8 5.2 2.6 6.4

M2 Multiplierc 3.4 3.4 3.8 5.0 5.4 6.7 7.7 7.0 7.8 7.4 8.0 7.5 7.6 7.7 8.2

M2/Forex Reserves (%) 414.2 415.4 367.5 481.5 597.2 596.8 539.0 552.6 602.3 643.4 690.3 638.6 419.9 407.5 549.1

Nonperforming loans (%)d na na na na na na 9.2 na 14.2 12.1 10.4 8.8 14.0 63.3 63.8

Of which: Bad Debt na na na na na na 1.7 na 3.3 4.0 3.3 2.9 2.3 23.4 28.5

Cash-assets/Deposit Ratio (%) 15.9 13.3 12.4 14.5 11.1 6.5 13.7 3.2 2.6 2.5 2.6 4.7 5.8 8.2 7.5

Loans/Assets Ratio (%) na 53.3 58.2 61.5 65.4 73.4 76.2 73.7 75.4 80.3 79.2 77.0 71.9 70.9 66.7


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aggravated an already-unfolding recession as trad-

ers and producers find their credit lines cut.

Meanwhile, faltering economic activity, sudden

depreciation of the rupiah, high interest rates, and

the bank run have dealt a devastating blow to the

financial system. Banks became illiquid as clients

withdrew their deposits and BI supported the rupiah

by cutting back base money supply. Banks’ equity

has been sharply eroded because of the sudden de-

valuation of the rupiah and high inflation rates.

Surges in Capital Inflows andLendingThe banking reforms which started in October 1988

have “overstretched” the banking system, as shown

by the rising loan-deposit ratio (LDR) and excessive

credit expansion. Following the reforms, LDR of the

banking sector rapidly rose from 106 percent in 1988

to 129 percent in 1992 and peaked at 138 percent in

1995 (Table 5), much higher than the maximum al-

lowable 110 percent. On the average, credit outstand-

ing of commercial banks increased by over 24 per-

cent per annum in 1992-1997, or three times the av-

erage annual growth rate of GDP. The average an-

nual growth rate of bank loans was also much higher

than that of the manufacturing industry, the most

dynamic sector of the economy.

Rapid credit expansion was induced by a combi-

nation of factors: (i) lifting of restrictions on bank

lending and regulations on asset portfolios, (ii) low-

ering of reserve requirements, (iii) market opening,

(iv) privatization, and (v) greater access to offshore

markets. The presence of new entrants in a more

competitive market environment may well increase

the pressure on banks to engage in riskier activities.

Yet bank credit officers reared in an earlier, more

controlled environment may not have the expertise

needed to evaluate new sources of credit and mar-

ket risk. When the economy is booming, it is difficult

to distinguish between good and bad credit risks be-

cause most borrowers look profitable and liquid. When

restrictions on bank lending were lifted, banks im-

mediately extended more credit to land-based indus-

tries and excessive infrastructure projects. Part of

the credit expansion was financed by foreign bor-

rowings, while the surge in private capital inflows

drove up equity prices.

The financial sector reforms relaxed requirements

for domestic banks’ foreign exchange transactions

and for opening branch offices overseas. They also

allowed greater penetration of the domestic economy

by foreign banks and larger ownership of domestic

assets by foreign investors. Moreover, the new rules

and regulations replaced the administrative ceilings

on offshore borrowings of commercial banks with a

more rational system of net open position. Along with

privatization, the authorities abolished the limits for

inflow of foreign direct investment and foreign own-

ership of equities issued in domestic stock markets.

Since 1971, Indonesia has adopted a relatively open

capital account and managed a unitary exchange

rate.6 Under this system, export proceeds, taxes, or

subsidies on the purchase or sale of foreign exchange

need not be surrendered. Indonesian citizens and

foreign residents are free to open accounts either in

rupiah or in foreign currencies at banks that are au-

thorized to extend credit in foreign currency.

To encourage foreign investment, BI made a spe-

cial exchange rate available to domestic borrowers

by providing an explicit subsidy on the exchange

rate through the exchange rate swap facility from

January 1979 to December 1991. It provided for-

ward cover to foreign exchange borrowing contract

swaps to banks and nonbank financial institutions

(NBFIs), and to customers with foreign currency

liabilities. The subsidy was a result of the time lag

in either an upward adjustment of the swap pre-

mium or a nominal depreciation of the rupiah, or a

combination of both.

Foreign investors’ herd behavior also increased

capital inflows and outflows. They bought stocks, com-

mercial paper, and even real estate, and invested in

excessive infrastructure projects. The reforms, which

cover nearly all aspects of the economy, combined


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deposits. A number of indicators point to a rising

percentage of debt instruments denominated in for-

eign currency, particularly the dollar, including the

higher ratios of (i) broad money (M2) to GDP, (ii)

dollar deposits as percentage of M2, (iii) dollar credit

as a percentage of total credit, and (iv) excess li-

quidity of commercial banks held in dollars (Table

6). As emphasized by Calvo (1994) and Mishkin

(1997), these make it more difficult to manage both

the banks’ portfolio and the macroeconomy. An ex-

pansionary policy, for example, is likely to devalue

the rupiah and raise the inflation rate.

When domestic interest rates are high, banks are

strongly tempted to denominate debt in foreign cur-

rency. Bank devisas (those licensed to deal in for-

eign exchange transactions) turn to short-term, for-

eign-currency-denominated borrowing in the inter-

bank market to fund longer-term bank loans. The

ratio of external liabilities of the commercial banks

to their assets rose from 9.5 percent in 1993 to over

18 percent in March 1998. The ratio of net external

liabilities to total liabilities also grew fast from -14.1

percent in 1988 to 0.9 percent in 1990, 4.9 percent in

1993, and 5.2 percent in 1997. External borrowings

of the financial sector increased from $6 billion in

1993 to $12.1 billion in 1995, but fell to $11 billion in

1996 and $10.1 billion in mid-1997 (J.P. Morgan

1997:3 and 1998:70).

with the perception of Indonesia as a stable country

and one of Asia’s success stories,7 attracted massive

capital inflow to Indonesia beginning in the early 1990s.

Demand for securities issued by both State-owned

and private companies increased as foreigners were

allowed to own up to 49 percent of the listed shares of

national companies (except banks). National compa-

nies were also permitted to raise funds by selling se-

curities in domestic and international stock and bond

markets. Capital inflows were encouraged further as

domestic interest rates (adjusted for relatively limited

actual exchange rate movements) rose and were sus-

tained through the 1990s. Peregrine, an investment

bank based in Hong Kong, China, collapsed in early

January 1998 due to a single massive bad loan ($265

million) to PT Steady Safe, a local taxi company in

Jakarta. Steady Safe used $145 million to buy 14 per-

cent of a toll road building company owned by Siti

Hardiyati Rukmana (Tutut), former President Suharto’s

eldest daughter, who was then named to Steady Safe’s

board (Spaeth 1998).

Increasing Bank Liabilities withLarge Maturity/Currency MismatchesA combination of liberal capital account, financial

sector reforms, and advances in technology and in-

formation processing has made it easier for Indone-

sian banks to alter the currency composition of their

Table 6: Selected Indicators on Dollar-denominated Instruments

Ratio of Credit Ratio of Excess Liquidityin Dollar to Dollar Deposits in Dollar to Total Liquidity

M2/GDP (%) Total Credit (%) to M2 Ratio (%) of Commercial Banks (%)

1990 43.0 12.2 20.6 9.1

1991 43.6 15.6 21.2 7.4

1992 46.4 17.9 20.8 12.0

1993 44.0 19.4 21.7 12.8

1994 45.7 19.1 21.7 8.3

1995 49.0 19.5 19.8 5.7

1996 54.2 19.9 19.5 4.0

1997 56.9 30.8 31.1 6.1

1998 58.3 35.8 24.8 21.1

1999 na 34.2 21.3 11.5

na = not available.Source: Bank Indonesia, Indonesian Financial Statistics, various issues.


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Partly because of the historically predictable and

low rate of the rupiah depreciation, a large portion

of the external debt is unhedged. This not only makes

banks and their customers more vulnerable, but also

makes it harder to deal with banking crisis, rise in

interest rates, and sharp devaluation of the rupiah.

The rupiah’s depreciation caused banks’ and firms’

balance sheets to deteriorate because much of their

debt is denominated in foreign currencies. It rap-

idly raised the cost of renewing or rolling over the

short-term floating rate dollar or yen loans in real

terms. As Indonesian banks’ and firms’ indebted-

ness rose, their net worth fell. Banks became more

vulnerable as their capacity to absorb negative

shocks declined because of currency and maturity

mismatches. The rise in interest rates caused the

banks’ and banks’ customers’ balance sheets to

deteriorate.

The risk of maturity mismatch is higher for un-

listed banks, which cannot mobilize long-term sources

of funding (bonds, shares, and other types of securi-

ties) in stock markets. Selling equity in stock mar-

kets can also spread or distribute the risk. Risk is

high as most companies rely exclusively on bank

loans for financing, with land as the main collateral.

Only a handful supplement bank finance with equity

offerings. The high loan/value ratio of bank loans to

companies, such as property developers, exposed

banks to sharp declines in real estate prices. This

and the plunge in equity prices depressed the market

value of collateral and bank assets. The liquidity prob-

lem became more difficult because mortgages were

not securitized and there was no market for Govern-

ment bonds.

Weak Financial Positions ofBanks and Highly ConcentratedProblem LoansLiberalization of the banking industry will surely pro-

duce long-term benefits for Indonesia. In the short

run, however, deregulation inevitably exposed banks

to new risks, which led to the current banking crisis.

Despite Indonesia’s relatively high economic growth

of more than 6 percent per annum since 1990, the

national banks’ bad-loan problems have not dimin-

ished significantly. As Table 7 shows, they were more

severe at State-owned and nonforeign-exchange

banks. State-owned banks were the main providers

of credit programs, with subsidized interest rates,

during the long period of financial repression. They

are also the main victims of erratic Government poli-

cies, such as those that shifted public deposits from

them to the central bank. As of September 1998,

bad debts amounted to Rp42.4 trillion (equivalent to

about 2 percent of GDP or around 10 percent of

total loans), of which Rp7 trillion (68 percent) be-

longed to State-owned banks. The State-owned PT

Bapindo is technically insolvent as its bad loans are

much greater than its capital.

Close to 12 percent in 1995, the actual average of

risk-based capital ratio of all commercial banks was

higher than the Basle minimum standard for capital

adequacy ratio (CAR) of 8 percent. According to

the World Bank (1996), 22 banks (out of a total of

240 banks in mid-1995) did not meet CAR and 65

banks did not follow the legal lending limit regula-

tions, which restrict the aggregate amount of loans

and advances to insiders, a single borrower (person

or firm), or group of borrowers.8 It was reported

that on average over half of private bank loans were

given to companies in the same groups. Over 90 per-

cent of the loans of PT Bank Dagang Nasional In-

donesia and PT Danamon, two of the largest private

banks, were channeled into their own groups. Tradi-

tionally, State-owned banks were undercapitalized.

The low capital requirements of the past were hardly

enforced for these banks because it was presumed

that the Government would stand by them and that

their insolvency would just be reflected in the fiscal

balance.

Overstaffing and overextended branch networks

are also more prevalent among State-owned banks.

Because they are protected from closure on con-

stitutional grounds and since losses are covered by


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the public budget, State-owned banks tend to have

lower incentives to innovate, promptly identify prob-

lem loans at an early stage, and control costs. As

risks of State-owned banks are assumed by the

State, lending skills (including risk appraisal) of bank

officers are generally weak. These banks’ loan-

loss performance is usually inferior to that of their

private counterparts.

Heavy Government Involvement inSelection of Credit CustomersDespite privatization, the six State-owned banks

(Bank Bumi Daya, Bank BNI, Bank Exim, Bank

Rakyat Indonesia (BRI), Bapindo, and Bank

Tabungan Negara) still retain over 30 percent of to-

tal bank assets. This figure would be even higher if

computed assuming a broad definition of indirect

ownership, as BI, State-owned banks, line ministries,

and various branches of the armed forces also own

banks. The relatively high degree of State owner-

ship shows how political objectives intrude in almost

all aspects of bank operations, including personnel

and technology. It also encourages recourse to pub-

lic financing of bank bailouts.

For decades, loan decisions of State-owned banks

were subject to explicit or implicit Government di-

rection. All too often, creditworthiness of the bor-

rowers did not receive sufficient weight in credit

decision, so that State-owned bank loans were ve-

hicles for extending Government assistance to par-

ticular industries and a handful of politically well-con-

nected business groups. The conglomerates con-

trolled a large proportion of GDP and a vast range of

mainly rent-seeking activities. Deregulation has not

ended Government intervention in lending decisions

of State-owned banks and financial companies: busi-

nessman Edi Tansil and PT Timor Putra Nusantara

received credit even after the banking reforms and

allegedly at the behest of those who promoted the

reforms. Edi Tansil is a business partner of Hutomo

Mandala Putra (Tommy), former President Suharto’s

youngest son, in Golden Key Group. PT Timor Putra

Nusantara is jointly owned by Tommy and KIA Motor

Corporation.

Table 7: Commercial Banks’ Classified Credits, 1995–1998

na = not available.a The decline of bad loans to 13.4 percent of total credit at State Banks in April 1997 was mainly due to the write-off of bad loans at Bank Rakyat Indonesia in preparation for their

privatization.Sources: World Bank 1997; Bulletin Info Finansial 39/VIII, 16 July 1997; and Bank Indonesia, Recent Macroeconomic Indicators, various issues.

Item 1995 1996 Apr 1997 Mar 1998 Jun 1998 Sep 1998 Dec 1998

Total Credit (Rp trillion) 267 331 350 477 626 536 487

Classified Credits (% of total credit)

Substandard 2.7 2.6 2.8 6.9 16.6 19.3 13.5

Doubtful 2.4 3.3 3.5 3.3 6.8 13.3 17.0

Bad Debt 3.3 2.9 2.3 2.9 5.4 7.9 23.3

Total 8.4 8.8 8.6 13.1 28.8 40.5 53.8

Distribution of Bad Loans by Bank Ownership (%)

State-owned Banks 72.7 67.0 65.9 na na na na

Private Banks 16.3 22.8 24.5 na na na na

Provincial Development Banks 5.5 4.9 4.8 na na na na

Foreign and Joint Venture Banks 5.5 5.3 4.8 na na na na

Total 100.0 100.0 100.0

Ratio of Bad Loans to Total Credit by Group of Bank Ownership (%)

All Banks na 10.4 8.8 na na na na

State-owned Banksa na 16.6 13.4 na na na na

Private Foreign Exchange Banks na 3.7 4.3 na na na na

Private Nonforeign Exchange Banks na 13.8 1.1 na na na na


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Bad GovernanceIn February 1991, along with market liberalization,

financial sector reform also included a more restric-

tive capital adequacy, asset quality, management,

earning, and liquidity (CAMEL) system to regulate

and supervise banks. Indonesia adopted rules and

regulations limiting loans extended to bank insiders

(owners or managers and their related businesses),

but these were not strictly implemented.

Poor implementation of the prudential rules and

regulations is due partly to structural weaknesses

in the legal and accounting systems. The regulators

and bank managers do not have sufficient person-

nel to supervise and examine the fast-growing num-

ber and expanding powers of financial institutions.

In an autocratic political system such as Indonesia,

regulators may operate more in the interest of the

rulers than in the interest of the people. The cases

of commercial paper issued by PT Bank Pacific,

PT Bank Arta Prima, and PT Bank Perniagaan in-

dicated fraud and collusion with BI bank supervi-

sors. Four BI bank supervisors were arrested in

early August 1997 for allegedly receiving bribes in

1993-1996. Corrupt officials may have used BI

funds to buy shares of problem banks and to pro-

vide low-cost and low-risk liquidity credit to the

troubled banks. Underregulation of banks leads to

excessive investment (McKinnon and Pill 1996).

Moreover, as private banks belong to business con-

glomerates, they are not tough on affiliated compa-

nies as they can expect assistance from the central

bank. Attaching collateral is a costly and time-con-

suming process, reducing the effectiveness of col-

lateral in solving the problem of adverse selection

(Mishkin 1997).

Lender of Last ResortIndonesia has neither a deposit insurance scheme

nor a bailout program for domestic banks facing runs.

BI, however, provides ad hoc and nontransparent

support, including capital injection, liquidity credit, and

emergency financial assistance. To strengthen pri-

mary (Tier I) capital of commercial banks, BI ac-

quires shares of problem banks and provides them

with equity capital. The rapid growth of BI support

to distressed banks is reflected in the fast-rising

claims of the monetary system on the private sector,

including claims of the central bank on commercial

banks.

A combination of weak market infrastructure,

misfeasance, malfeasance, and malversation has al-

lowed certain individuals to misuse their banks by,

for example, swindling people out of their deposits

and using equity share and liquidity credit from the

central bank to issue fake commercial paper and to

obtain offshore loans, without proper backup for the

bank owners’ questionable projects, usually at inflated

prices. Liabilities of these banks are mainly deposits

owned by the general public, liquidity credit from BI,

unsecured commercial paper sold to the general public

(including foreigners), and equity shares owned by

BI and other State-related institutions. The latter in-

clude State-owned pension funds (such as PT

Taspen, the civil servants’ pension fund) and insur-

ance companies (such as PT Jamsostek, the work-

ers’ social insurance), and pension funds and other

financial resources administered by the enterprises

themselves and their cooperatives. Net worth of the

distressed banks is actually negative.

Newspaper reports indicate that the suspended

banks have long been saddled by financial problems,

surviving only because of financial resources from

the central bank. The reports also show that BI acts

as the lender of last resort only to State-owned banks

and politically well-connected institutions. The Gov-

ernment directed other State-owned enterprises

(such as PT Taspen and PT Jamsostek) to invest

and place deposits in banks and enterprises owned

by politically well-connected conglomerates. Pres-

sured to continually provide distressed banks with

lender-of-last-resort and other public sector funding,

BI often lent money to institutions that had no capital

and whose owners had no incentive to use the new

money wisely because they had nothing to lose. Aside


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from providing equity capital and credit, BI also ar-

ranged mergers, consolidations, and takeovers of

problem banks either by stronger institutions or new

investors.

Policy ResponsesTo address the crisis, Indonesia signed four economic

programs with IMF from October 1997 to June 1998

(Appendix). The first part of the IMF package is

designed to (i) restore macroeconomic stability and

economic growth and (ii) remedy structural weak-

ness in the economy by emphasizing short-run stabi-

lization and medium- to long-term structural reform,

including rebuilding market infrastructure. The pro-

grams outline a broad macroeconomic policy, which

includes (i) cutting domestic absorption and (ii)

switching expenditures from imports to domestically

produced goods and services. The second part of

the IMF package outlines broad economic reforms

to (i) remove impediments to market efficiency, (ii)

create a favorable climate for development, and (iii)

improve the efficiency of resource use. The struc-

tural reforms include (i) bank restructuring, (ii) re-

moval of regulatory and price controls in the product

and labor markets, (iii) efforts to tackle fiscal distress,

(iv) privatization of State-owned enterprises, and (v)

measures to improve market transparency. The re-

forms are expected to improve domestic market com-

petition by dissolving monopolies and opening up the

economy to foreign competition and capital.

The third IMF program of April 1998 also includes

frameworks for (i) Government assistance in solv-

ing the private sector’s external debt overhang and

(ii) budget subsidies for prices of State-vended prod-

ucts. The initiative to resolve the private sector’s in-

ternal debt problem was announced in early Sep-

tember 1998. On 24 September 1998, the Paris Club

creditor nations announced the rescheduling of $4.2

billion in principal repayments of Indonesia’s sover-

eign debt.

The 50-point IMF programs of January, April, and

June 1998 contain more detailed measures covering

(i) a wide range of fiscal, monetary, and banking poli-

cies; (ii) foreign trade; (iii) investment and trade de-

regulation; (iv) privatization and public enterprises;

(v) social safety nets; (vi) the environment; (vii) a

monitoring system for structural reforms; (viii) cor-

porate restructuring; (ix) competition policy; and (x)

rebuilding the legal system. The short-run stabiliza-

tion program and a wide range of medium- and long-

term structural reforms have to be completed by

March 1999.

Confusing and Conflicting PoliciesInconsistent implementation of the stabilization and

reform programs, and the social unrest that marked

the end of the Suharto regime on 21 May 1998 (see

Johnson 1998) eroded both domestic and international

confidence in the Government. Confusing policies

raised the velocity of money, triggering bank runs,

panic buying, and capital flight. The outflow of pri-

vate capital magnified the need for capital inflow to

defend the rupiah because of rising demand to pay

back short-term external debt. Moreover, the delay

in taking measures to restrict aggregate demand, in-

cluding fiscal tightening and monetary policy adjust-

ment, encouraged the private sector to convert rupi-

ahs into dollars.

The first sign of policy confusion was evident af-

ter the October 1997 IMF program, when the au-

thorities funneled the new loans back to the politi-

cally well-connected business groups’ excessive in-

frastructure projects that had been shelved in the

previous month. The projects were shelved again

under the revised IMF packages in January 1998.

The second sign was the closing of some banks in

November 1997 and tight liquidity. As part of the

conditions for receiving a $43-billion bailout from IMF,

the authorities revoked the operating licenses of 16

financially distressed private banks.9 Rather than

injecting more liquidity into the system while weed-

ing out the weak banks, they even squeezed liquidity

by shifting public sector deposits into the central bank,

thus tightening monetary policy. Because the banks


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were inadequately supervised, people could not dis-

tinguish between good and bad banks. All these set

off capital flight and bank runs as depositors with-

drew their deposits from domestic banks and trans-

ferred them to foreign banks in Indonesia and over-

seas. The worsening banking crisis, the rupiah’s con-

tinuous plunge, rising inflation, and concern about the

President’s health sparked panic buying and capital

flight. In January 1998, housewives discarded the

rupiah for staple goods and foreign currencies.

Since 20 February 1998, to restore public confi-

dence, the authorities have provided a blanket guar-

antee against losses to depositors by returning all the

money blocked in the liquidated banks. To prevent the

bankruptcy of BI, its role as lender of last resort has

been shifted to the Treasury through the Indonesian

Bank Restructuring Agency (IBRA). As the Trea-

sury has no resources, the funds are to be borrowed

from the central bank and repaid over 10 years. This

monetized the Government rescue credit to ailing banks.

The third sign was the Government’s standoff with

IMF and international donors. President Suharto

called the IMF program unconstitutional, saying that

it went against the principle of the family-based

economy. Fed up with the rupiah’s slide, the authori-

ties toyed with the idea of adopting a currency board

system (CBS) that would peg the rupiah to foreign

currencies. However, the market, IMF, and major

economic powers publicly disapproved the CBS sim-

ply because Indonesia did not have the key ingredi-

ents necessary for the system’s success.10

The pro-

posal had merit as the system would automatically

stop credit to distressed banks, the public sector, and

favored industries and companies, but temporary fi-

nancial support is often vital for banking stability.

The fourth sign was the appointment on 14 March

1998 of Cabinet ministers who were generally per-

ceived as incompetent, including Mohammad (Bob)

Hasan, a close confidant and business partner of

President Suharto, as minister for trade and industry,

and President Suharto’s eldest daughter as minister

for social affairs.

The IMF program began to work under President

Habibie. Nevertheless, strong leadership and sound

public policies—the basic ingredients needed to solve

the crisis—were also missing from his administra-

tion. Suharto’s immediate successor has not been

able to erase his reputation as a crony. President

Habibie was known as a big spender when he served

as minister for research and technology for over two

decades. He was concurrently president and direc-

tor of many now-defunct “strategic industries,” in-

cluding the National Technology of Aviation Indus-

try (PT Industry Penerbangan Teknologi Nusantara),

the aircraft manufacturing firm partly financed from

nonbudgetary sources, including reforestation funds.

Social Safety NetsThe malfunctioning financial system, worsening eco-

nomic recession, and surging prices have pushed

unemployment and underemployment rates up, de-

pressed labor and asset income, and put more people

below the poverty line. Because of a lack of access

to inflation and devaluation hedges, the income and

assets of the poor are most affected by the crisis.

The Government often tried to tame inflation by con-

trolling wages and prices. More frequent demonstra-

tions, looting, and other criminal activities all over the

country showed that the economic crisis had become

intolerable.

Indonesia has no accurate data on unemployment

and underemployment. A rough pessimistic estimate

put unemployment at about 15 percent in March 1998.

In 1996, about 37 percent of the employed were con-

sidered underemployed, as they worked less than 35

hours per week. Social problems were unevenly dis-

tributed across economic sectors and regions. All

urban economic sectors—construction, manufactur-

ing, trade, and other services—have been hit by the

crisis. The long drought was a boon for some agri-

cultural products such as tree crops and tobacco,

and for fishery, particularly in western Indonesia, but

a disaster in the poorest regions such as East Nusa

Tenggara, Timor, and Irian Jaya.


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Meanwhile, workers have lost over half their wages

to the rupiah’s sharp devaluation and rising prices of

food and other essentials such as education and health

services. The World Bank (1998) estimates that the

poverty level in urban areas is expected to increase

from 3.8 percent in 1997 to 8.3 percent in 1999, and

in rural areas from 13.7 to 17.6 percent.

To ease the short-run negative impacts of the eco-

nomic crisis, the Government introduced three types

of social safety nets:

• Programs that deal with the transitional social

costs of adjustment, including those that provide

income support. (The increase in secondary or

social income partly makes up for the erosion of

primary income. State-provided secondary in-

come is limited to administrative controls and

subsidies to keep prices of essential commodi-

ties at unrealistically low levels. Foreign aid helps

ease the food shortage.)

• Labor-intensive public work programs to tem-

porarily absorb the unemployed.

• Provision of health care through public hospitals

and village health centers (puskesmas) and of

education through primary schools.

Since the Government lacks money, it has no in-

come transfer (e.g., unemployment benefits) program.

Other sources of social income are private trans-

fers, mainly from extended families and charity or-

ganizations.

The distorted relative prices of State-vended prod-

ucts have begun to create problems. By limiting pro-

ducer prices of agricultural products (e.g., rice and

palm oil) the Government effectively taxes the farm-

ers and the agriculture sector, thus reducing incen-

tives to increase production. In fact, prices are so

low that food intended for human consumption is used

to feed livestock. The large wedges between do-

mestic and international prices encourage smuggling

of State-vended products to neighboring countries.

In addition, because those in the upper-income groups

in general consume more State-vended products (e.g.,

gasoline, electricity, and telephone services) than the

poor, subsidized prices benefit the well-off more than

the poor.

The delivery of scarce basic commodities is ad-

versely affected by the economic crisis, social un-

rest, and populist Government policies regarding dis-

tribution channels. Rising interest rates and perceived

risks, as well as the recent violence against ethnic

Chinese, who dominate the distribution systems, raise

the cost of maintaining inventory and encourage cash-

basis transactions. Government policy to replace the

well-established ethnic Chinese with less experienced

cooperatives and the pribumi (natives) may have

created employment, but it has not repaired the dis-

tribution systems.

The benefits of the present social security nets

are too accessible and too generous, making them

too expensive, distorting incentive systems in the la-

bor market. A number of policy approaches may

remedy these weaknesses:

• Identify the poor, partly by using the existing rela-

tively austere poverty line.

• Introduce either the cash benefit or in-kind sys-

tem to those below the poverty line. Eliminate

benefits for those above the line. Strengthen the

system so that it cannot be abused and eliminate

corruption to minimize costs.

• Create labor-intensive public works programs for

those not qualified for the cash or in-kind ben-

efits. Because much of the unemployment and

underemployment is structural and inasmuch as

some groups other than the unemployed are poor,

assistance needs to be coupled with other ben-

efits such as low-cost health care programs and

training schemes.

Measures that may support the well-functioning,

more flexible, and responsive labor markets include

(i) assisting workers to look for jobs in the outer

islands and abroad, (ii) helping deal with the fallout

from mass layoffs, and (iii) promoting training and

other public interventions to assist workers trans-

fer residence to get jobs or to learn another occu-

pation.


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Bank RestructuringEconomic recovery and export growth depend greatly

on the rehabilitation of the financial system, particu-

larly the banking industry. Otherwise it will be im-

possible to reduce the present punitively high lending

rates (nearly 40 percent per annum) and expand

credit, and thus use excess capacity and boost pro-

duction and exports.

The IMF program contains seven measures to

restructure the banking system:

• Encourage distressed banks to merge rather

than let them fail.

On 3 October 1998, the authorities announced the

merger of four State-owned banks (Bapindo, Bank

Dagang Negara, Bank Bumi Daya, and Bank Exim)

into one institution, PT Bank Mandiri.11

The corpo-

rate business of BRI was also transferred to this

bank, leaving BRI to fulfill its original purpose: to

serve the rural sector, small-scale enterprises, and

cooperatives. Deutsche Bank of Germany assisted

in the merger of these State-owned banks.

• Strengthen the capital base of bad banks by

merger, allowing new investors, including foreign-

ers and the Government, to inject capital into the

new bank.

Foreign institutions are expected to help in pack-

aging the bad debts by bringing in their expertise and

helping restore public confidence in the banking in-

dustry.

• Restructure the banking industry with the as-

sistance of IBRA, an independent “bridge”

agency under the auspices of the Ministry of Fi-

nance (MOF).

Established in January 1998, IBRA has two main

functions: (i) supervise the banks in need of restruc-

turing as well as oversee the restructuring process,

and (ii) manage the assets it acquires in the course

of bank restructuring. The interdepartmental Finan-

cial Sector Action Committee sets the overall re-

structuring policy guidelines. Committee members are

the (i) coordinating minister of economy, finance, and

industry; (ii) BI governor; (iii) minister of finance;

(iv) minister of trade and industry; (v) State minister

of planning; and (vi) head of Bappenas (National

Planning Agency).

IBRA’s Assets Management Unit (AMU) will pur-

chase the distressed banks’ nonperforming loans

(NPLs), including those of the four State banks and

nonperforming corporate credits of BRI. The take-

over of NPLs will allow banks to focus on their tra-

ditional activities (deposit taking and lending) and not

waste their resources on managing NPLs, which are

estimated to be 50-75 percent of all loans. Banks’

capability to extend credit will significantly increase

as IBRA purchases their NPLs for cash. The for-

mation of IBRA has also shifted the function of lender

of last resort from the central bank to the Treasury.

By taking over the NPLs, IBRA helps prevent BI’s

bankruptcy.

Of the 54 banks placed under IBRA supervision in

early September 1998, three were State-owned (PT

Bapindo, PT Bank Bumidaya, and PT Bank Dagang

Negara). As pointed out earlier, they were, along with

PT Bank Exim, merged into PT Bank Mandiri. Eleven

of the banks under IBRA were the provincial govern-

ments’ Bank Pembangunan Daerah (BPD). The 34

privately owned banks under IBRA supervision are

divided into two groups: 4 (PT Bank Central Asia

[BCA], Bank Danamon, PT Bank Prima Dana Fi-

nance Corporation Indonesia [PDFCI] and PT Bank

Tiara) are classified as viable and the other 30 as non-

viable. A viable bank has some franchise value and

useful infrastructure while a nonviable bank has none.

Since April 1998, the operations of 10 nonviable banks

have been either suspended or frozen.12

As a result,

23 banks or almost 10 percent of the 240 banks that

existed in July 1996, have been closed.

The viable banks’ shareholders are required to

repay intergroup loans and inject fresh capital and

management methods into their banks to improve

credit evaluation, credit management, and risk. The

banks were given until 21 September 1998 to repay

the intergroup loans and liquidity supports from BI.

Those unable to meet the deadline were classified


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as nonviable, their operating licenses immediately

revoked, and their shareholders made liable to repay

losses and required to transfer all the assets of the

shareholders to IBRA’s AMU. To give the banks

some breathing space, on June 1998 CAR was re-

duced to 4 percent until end-1998. The ratio was

raised to 8 percent at end-1999 and will be raised to

10 percent by end-2000.

Backed up by a Government guarantee, BI pro-

vided the credit to finance IBRA’s initial operation.

Additional funds are to be raised by issuing Govern-

ment bonds in international markets. Based on a con-

servative estimate of NPLs at 70 percent in 1998,

total funding requirement in the second quarter of

1998 was calculated to reach Rp440 trillion or 49

percent of annual GDP. Assuming that sharehold-

ers’ payment would reach 25 percent, that the NPL

recovery rate would be 20 percent, and that the sale

of banks would bring in Rp45 trillion, then funding

deficit would be as high as 22 percent of annual GDP

(Table 8). Over time, as recoveries increase, IBRA

will be able to finance itself.

IBRA will be wound up once the bank rehabilita-

tion program is completed. Given its expected lon-

gevity, IBRA can hold on to assets purchased until

their values rise again. Its financial losses will be

covered by the public budget. Collateral backing of

NPLs ranges from real estate and shares to toll road

and logging concessions. IBRA could buy a combi-

nation of performing or viable loans and NPLs, and

restructure them by injecting fresh capital and better

management methods into distressed but viable banks.

On the other hand, the distressed banks themselves

have the option to choose what NPLs they want to

retain. IBRA has hired international accounting firms

to evaluate NPLs’ values based on international com-

mercial standards.

• Restore the domestic and international com-

munities’ confidence in domestic banks by explic-

itly and fully guaranteeing demand, savings, and

time deposits of all banks in Indonesia.

Government should extend guarantees to credit

received and to guarantees and letters of credit is-

sued by the banks. The debts of the failed banks to

depositors and creditors are covered by the scheme,

but the credit received by bank owners and subordi-

nated debts are not. In two years, the scheme will be

taken over by the yet-to-be-established Deposit In-

surance Scheme, administered by IBRA. Participat-

ing banks are required to contribute a half-year fee

Table 8: Recapitalization Requirement of Indonesian Banks at Various NPL Estimatesa, Second Quarter,1998 (Rp trillion)

NPL Estimates

Item 50% 60% 70% 80%

NPL 323.2 387.8 452.5 517.1Provisioning (70%) 226.2 271.5 316.8 362.0Adjusted Asset 510.6 465.3 420.0 374.4Required Equity (8% of Asset) 41.0 37.2 33.6 30.0Required Recapitalization 236.0 257.9 299.6 341.6Bank Indonesia’s Existing Liquidity Credit 140.0 140.0 140.0 140.0Total Funding Requirement 376.0 397.9 439.6 481.6

(As Percentage of Annual GDP) 41.8 44.2 48.8 53.6Potential Sources of Funding:

Paid-in Capital from Shareholders (25%) 94.0 99.5 109.9 120.6Sale of NPLs (Recovery Rate: 20%) 64.6 77.6 90.5 103.4Sale of Banks 30.0 35.0 45.0 50.0

Funding Deficit 187.4 185.7 194.2 208.2(As Percentage of Annual GDP) 20.8 20.6 21.6 23.1

GDP = gross domestic product, NPL = nonperforming loan.a Based on total assets of the 54 banks under IBRA supervision amounting to Rp738.8 trillion, total risk assets of Rp646.4 trillion, and total equity of Rp50.8 trillion.Source: Indonesian Bank Restructuring Agency.


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of 0.05 percent of the guaranteed deposits and debts

to the Government guarantee scheme. Funds used

by BI to bail out depositors and creditors will be cred-

ited to the Government annual budget in tranches

over five years.

In the short run, the scheme will reduce bank runs,

which began after the closure of 16 banks in early

November 1997. In exchange for the guarantee, all

locally incorporated banks must submit to enhanced

supervisory oversight. Those that fail to meet BI stan-

dards are to be reviewed by IBRA. The scheme is

expected to restore the confidence of the interna-

tional community, which refuses to accept letters of

credit opened by Indonesian banks. In the long run,

however, the credit insurance scheme will create

moral-hazard problems, particularly because the eco-

nomic infrastructure is weak.

• Make operations of State-owned enterprises,

including State banks, more transparent and ac-

countable.

The performance of State bank managers will be

judged according to criteria detailed in performance

contracts. Political corruption can be significantly re-

duced by making State-owned enterprises more in-

dependent and by cutting their links to Government

bureaucracies.

• Strengthen BI by giving it full autonomy to

formulate and implement monetary policy.

A draft of the new central bank law is being pre-

pared and is soon to be presented to Parliament.

• Improve market infrastructure, including pru-

dential rules and regulations governing the fi-

nancial system, along with measures to strengthen

BI’s capability to enforce them and to supervise

the banking industry.

Fiscal Distress andStabilization ProgramThe meltdown of the Indonesian economy and the

collapse of its banking system have worsened fiscal

imbalance and sent inflation rates soaring. The bud-

get deficit grew mainly because of the rapid increase

of fiscal and quasi-fiscal Government expenditures.

In contrast, Government revenues have been declin-

ing in real terms due to the economic recession, ris-

ing unemployment, and high inflation. The economic

crisis has also limited the public sector’s access to

international markets for financing its budget deficit.

Because of low domestic saving, the local market

remains very shallow.

The financing constraints have put pressure on

the Government to redefine its scope. The budget is

no longer seen primarily as a tool of resource alloca-

tion (including “KKN”—corruption, collusion, and

nepotism), but as a macroeconomic instrument and

vehicle for providing public goods. The task of re-

source allocation should be given to the market. As

an instrument of the stabilization program, the Gov-

ernment budget and underlying fiscal and quasi-fis-

cal deficits need to be consolidated by integrating

and consolidating nonbudget revenues and expendi-

tures into the formal budget.

The key to fiscal consolidation is to raise Govern-

ment revenues from both tax and nontax sources.

This requires tax reforms and measures to improve

tax administration and to reduce the scope of State-

owned enterprises. Revenue from value-added tax

(VAT) can be raised by enlarging its base to include

products from which the tax can be easily collected

at minimal cost—for example, electricity, drinking

water, alcoholic and soft or nonalcoholic drinks, and

other products usually consumed by middle- and high-

income groups. The VAT-exempt status of imported

capital goods used by shopping malls, hotels, and the

public sector should be removed. The low income-

tax ratio (1.39 percent of GDP in 1996) and the small

number of taxpayers as a proportion of population

(0.5 percent in 1989, the lowest in ASEAN), indi-

cate widespread tax evasion and underreporting. It

is worth emulating the attempts of Hong Kong, China,

to raise revenue from income tax and to reduce its

collection cost by imposing a single rate of 15 per-

cent. The low revenue from property tax is partly

due to poor information or records on land and prop-


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erty holdings and market values, annual income and

expenses on property, land surveys, topography, and

other physical factors (UN-ESCAP 1995).

Government expenditures will consist of debt and

nondebt outlays. The Paris Club decision in Septem-

ber 1998 to reschedule $4.2 billion in principal pay-

ments of Indonesia’s sovereign debt to 19 creditor

nations greatly eased the pressure on the balance of

payments. The principal of soft loans ($500 million)

is to be repaid over 20 years with a five-year grace

period, and that of export credit ($1.2 billion) over 11

years with a three-year grace period. The agree-

ment also gives the Government a generous 20-month

consolidation period by rescheduling the repayment

of $700 million in soft loans and $1.2 billion in export

credits due in August-March 1999. Instead of rolling

over its loans maturing in FY1999, the Japanese Gov-

ernment has provided Indonesia with new untied

loans amounting to ¥1.3 billion for refinancing pur-

poses. The Government commercial external debt,

amounting to $2.26 billion, (made up of $426 million

in outstanding bonds and $1.84 billion in syndicated

loans), is to be rescheduled by the London Club.

The next biggest item in the Government budget

is expenditure for social safety nets, including subsi-

dies on prices of State-vended products. The poli-

cies to review and cancel Government contracts that

were obtained through corruption, collusion, and nepo-

tism help reduce Government expenditures. How-

ever, the Government’s contingency liabilities will

come from three sources: (i) implicit and explicit sub-

sidy on private sector infrastructure projects, (ii) fi-

nancial losses incurred by IBRA for (a) restructur-

ing ailing commercial banks and (b) providing a fi-

nancial blanket guarantee against losses to deposi-

tors, and (iii) the Indonesian Debt Restructuring

Agency (INDRA) exchange rate subsidy for repay-

ment of private sector external debt.

Just as important as the increase in the public sec-

tor deficit is the substantial shift to inflationary means

of financing deficit. The rapidly rising budget deficit,

from 1 percent of annual GDP in FY1998 to 8.5 per-

cent in FY1999 (Table 9), cannot be sustained. Since

the late 1960s, the essence of fiscal policy in Indone-

sia has been to cap the public budget deficit to a level

that can be financed by external borrowings, mainly

concessionary development aid from official sources.

As part of the $43-billion IMF package, foreign do-

nors pledged to provide $14 billion to finance the bud-

get deficit. No foreign donors are willing to continue

to provide such large budget supports. Moreover, this

external borrowing strategy is just deferred taxation.

To repay the external debts, the Government has to

raise revenue through taxation and to promote exports

in order to acquire foreign currency. Recently, part of

the deficit has also been financed by the proceeds

from privatization of State-owned enterprises. Because

of the availability of these sources of financing, the

Treasury does not have to borrow from the central

bank. In January 1998, the authorities began to bor-

row from BI to pay for IBRA’s operations. Printing

money to pay for a public deficit appears to be a soft

option, as raising taxes and selling State properties are

unpopular and unpleasant.

Table 9: Government Budget (% of GDP)

FY 1997/98 FY 1998/99Item Actual Revised

Revenues 16.2 15.7Oil and Gas 4.6 5.2Nonoil 11.6 8.9Privatization 0.0 1.6

Current Expenditures 10.6 17.0Subsidies 3.1 6.2Interest 1.7 3.3Others 5.8 7.5

Government Savings 5.6 (1.3)Development Expendituresa 6.6 7.2

Social Sectorsb 1.0 1.6Special Employment Schemes 0.0 0.9Others 4.6 4.7

Budget Deficit 1.0 8.5Financed by:

External Finance 1.6 4.8Domestic Finance (0.6) naExceptional Finance na 3.7

na = not available.( ) = negative values are enclosed in parentheses.aSum of components may not add up to total due to rounding.b Include education, health, food production and small scale credit.Source: Ministry of Finance.


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Private Sector Debt OverhangThe corporate sector’s rehabilitation and resumption

of access to international and domestic financial

markets are preconditions for the restoration of pro-

duction and exports. The exclusion from international

capital markets affects the private sector most as it

is the main debtor to foreign creditors. Out of $72.5-

billion private sector external debt outstanding, about

$30 billion fell due in March 1998.

In its policy statement of 27 January 1998, the

Government proposed to temporarily freeze servic-

ing the private sector’s external debts. It also made

clear that corporate debt problems should be solved

on a voluntary basis between borrowers and lend-

ers. The Government should not provide financial

resources, subsidies, or guarantees to bail out com-

panies that cannot survive surging real interest rates,

sharp devaluation of domestic currency, and falling

sales. Private sector default would be permitted, even

in the financial sector, as the Government would nei-

ther rescue those in financial difficulty nor guaran-

tee their external debts and repackage them into a

Government bond issue. Otherwise, creditors would

certainly lose (as Peregrine did), reducing Indonesia’s

access to international financial markets. Some of

the losses can be shifted to taxpayers through tax

credits in the source countries.

To relax the external debt constraint, the IMF pro-

gram of April 1998 addresses the private sector’s

short-term external debt. The agreement reached in

Frankfurt, Germany, on 4 June 1998, between repre-

sentatives of the Government and the private sector

and the steering committee of foreign lenders pro-

posed solving the private sector’s external debt prob-

lem through a scheme combining features of Mexico’s

Ficorca and Korea’s programs. The Korean-inspired

program would take the short-term, nontrade debts

of Indonesian banks ($8.9 billion) and restructure them

into loans with one- to four-year maturities. Interest

on the new loans would be paid based on LIBOR

(London interbank offered rate) plus margins, rang-

ing from 2.75 to 3.5 percent, about 50 basis points

wider than the original Korean agreement. The non-

bank corporate external debt ($58.79 billion) would

be rescheduled and restructured along the lines of

the Mexican program. INDRA, a trust institution,

would be established by the Government and admin-

istered by BI. It would “provide exchange rate risk

protection and assurance as to the availability of for-

eign exchange to private debtors that agree with their

creditors to restructure their external debt for a pe-

riod of eight years, with three years of grace during

which no principal will be payable.”13

In September 1998, the authorities announced the

Jakarta Initiative to help solve the private sector’s

$65-billion domestic debt by forming a task force to

facilitate and coordinate the restructuring process.

The task force works closely with the Corporate

Restructuring Advisory Committee (consisting of

representatives of domestic and foreign financial in-

stitutions, IBRA, and INDRA), which recommends

solutions to the debt workout problems. The legally

nonbinding principles being used to solve the prob-

lems are based on out-of-court commercial negotia-

tions between debtors and creditors. The elements

of the framework include the appointment of profes-

sional legal and financial advisors by each distressed

debtor. Debt restructuring requires accurate and

timely financial information from the debtors. On the

other hand, the creditors must agree to a “standstill”

or not charging default interest payment and other

penalties. They are to be treated as equals of equity

holders, who suffer the first losses.

As of October 1998, INDRA and the Jakarta Ini-

tiative have not made significant progress in resolv-

ing debt issues. In anticipation of a rebound in the

rupiah, and making use of the weak legal system,

many debtors have adopted a strategy of slowing

down the negotiation process by withholding infor-

mation and blocking auditors, valuers, and lawyers

from conducting the required investigations. Some

debtors continue to move funds and shift assets from

one distressed subsidiary to another without the con-

sent of the creditors.


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OutlookThe recent depreciation of the dollar and signifi-

cantly improved implementation of the IMF program

have resulted in the rapid appreciation of the ru-

piah. Its nominal value against the dollar rose sharply

from Rp11,550 in mid-September 1998 to Rp7,800

on 20 October 1998, an encouraging development

that helped lower interest and inflation rates and

rehabilitate the banks and corporate sector. The

reduction in lending interest rates and expansion of

credit will allow the corporate sector to increase its

utilization of existing capacity and to take advan-

tage of the nonoil export industries’ enhanced prof-

itability.

The rising growth rates of agricultural products

as well as oil and nonoil exports are expected to be

the main factors to revive the economy. Agricultural

output is expected to rebound with the resumption of

normal weather conditions. Petroleum, rubber, wood-

based products, copper, and coal still account for over

half of Indonesia’s total merchandise exports. Their

prices fell sharply in 1997. The turnaround of nonoil

exports is likely to occur with the upturn of commod-

ity prices. Measured in volume terms, Indonesia’s

export growth remains strong at 32.8 percent in the

first quarter of 1998.

ConclusionAt the root of the present financial crisis are the over-

invested and highly protected nontraded and manu-

facturing sectors and the weak financial system. The

crisis was aggravated by the Government’s lack of

sound macroeconomic management and by the po-

litical crisis and social protest against the 32-year-

long authoritarian regime of President Suharto. The

low quality of investment was funded by massive

short-term capital inflows as shown by the widening

current account deficit and mounting external debt.

Overinvestment with low quality implies that fewer

resources were devoted to expand the economy’s

productive capacity and to enhance its ability to ser-

vice and reduce external liabilities. Overinvestment

also caused asset overvaluation, especially in the

real estate sector.

The rising share of capital inflows (in the form of

short-term bank borrowings and portfolio flows) in-

vested in the stock market and in private sector in-

struments made the financial system even more vul-

nerable. Surging local interest rates and the deep

depreciation of the rupiah raised the cost in real terms

of renewing or rolling over short-term floating rate

dollar and yen loans. To some extent, the authorities

had influenced both the size and composition of the

volatile short-term capital inflows by imposing ceil-

ings on them and raising their costs.

As indirect policies (enforcement of prudential

rules and regulations, for example) cannot restrain

expansion of liquidity and widening of the current

account deficit, the authorities used direct adminis-

trative controls, including eliminating the subsidy of

the exchange rate swap facility and reinstituting ceil-

ings on the private sector’s external borrowing. The

link between the base money and broad money was

weakened by the rise in the nonremunerated reserve

requirement ratio and the introduction of a credit plan

which directly sets specific credit growth targets for

individual banks. Previously, moral suasion was ap-

plied only to lending to land-based industries. To sup-

port sterilization operations, MOF forced State-owned

enterprises to shift their deposits, mainly in State-

owned banks, to the central bank, thus drying up li-

quidity.

The massive capital inflows caused the rupiah to

appreciate, reducing the domestic economy’s com-

petitiveness in the international market and providing

incentives to invest in the nontraded sector. Because

it was not supported by proper fiscal and monetary

policies and a healthy banking system, the exchange

rate band system could not be maintained by the cen-

tral bank and was abandoned and replaced by a float-

ing system on 14 August 1997. This move caused

the rupiah to depreciate sharply, raised interest rates

to punitive levels, sharply pushed up the share price

index, and tightened the internal and external liquid-


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ity crunch, pushing banks and their clients to bank-

ruptcy, lowering growth rates, and raising both un-

employment and inflation rates. The economic re-

cession depressed investment and pushed down as-

set prices. Along with the closing of 16 financially

distressed private banks in November 1997, it trig-

gered the bank run, capital flight, and panic buying,

and made foreign banks reluctant to accept Indone-

sian letters of credit. Even domestic banks became

reluctant to lend to each other.

The financial system, particularly the banking sys-

tem, is plainly dysfunctional because of a combina-

tion of bad central bank policies and direct Govern-

ment intervention in selection of banks’ credit cus-

tomers. The private sector banks also risk moral haz-

ard as they are lax with respect to their sister com-

panies in their business groups. Rebuilding the shat-

tered financial system requires strengthening both

the central bank and commercial banks. State-owned

banks and nonbank enterprises need to be sepa-

rated from the Government bureaucracy and

corporatized. In addition, market infrastructure

should be improved in order to enforce prudential

rules and regulations, promote competition, and

implement strict credit policies.

The revised IMF programs announced on 15 Janu-

ary and 8 April 1998 focus on further reform in trade

and investment policies, the financial system, and

market infrastructure. They are good starts to

strengthen economic institutions, improve domestic

competition, increase efficiency, and remove distor-

tions that restrain exploitation of Indonesia’s com-

parative advantage in labor-intensive and natural-re-

source-based sectors. To restore public confidence

in the banking system and thus speed up the bank

restructuring program, the Government guarantees

claims of depositors and creditors of banks operat-

ing in Indonesia. The social and political costs of the

adjustment program are, however, very high. Con-

tracting domestic expenditures and economic growth

and rising bankruptcies have also pushed up the un-

employment rate. The distributive effect of the ad-

justment program was partly influenced by the struc-

ture of the expenditure cut and the absence of ef-

fective social safety nets for the poor.

Fiscal consolidation is the key component of

Indonesia’s stabilization and adjustment programs.

Its main objective is to eliminate fiscal and quasi-

fiscal deficits that cause high inflation. Fiscal disci-

pline requires the integration into the formal budget

of the Government’s nonbudgetary transactions or

quasi-fiscal operations that are off the balance

sheets of budgetary units. Deficit reduction requires

raising revenues and decreasing expenditures. On

the revenue side, the widening tax base following

the tax reforms of the early 1980s and 1995 en-

hanced fiscal flexibility. Meanwhile, the removal of

egregious marginal tax rates and replacement of

the cascading sales tax with a more neutral VAT

helped raise economic efficiency and improved ex-

ternal competitiveness. Nevertheless, the tax ad-

ministration still has to be improved. State-owned

enterprises need to be restructured in order to help

strengthen the State’s fiscal position and to prevent

them from obtaining excessive bank credits. On the

expenditure side, fiscal consolidation includes cut-

ting subsidies on State-vended products, reducing

public investment spending, and creating cheap

credit from State-owned banks. Bank restructuring

has to be sped up in order to restore public confi-

dence in the banking system and lessen pressure

on the public budget.

The rupiah has appreciated recently and foreign

reserves have also posted a slight increase. Under

the IMF program, foreign aid has been coming in,

and external liability was temporarily reduced with

the rescheduling of public external debt. The pres-

sure for external debt repayment is expected to ease

further with the resolution of private sector debt. The

private sector debt issues have been mainly resolved

through two initiatives: (i) INDRA, which gives pro-

tection against exchange rate risk on external debt;

and (ii) the Jakarta Initiative, which provides the

framework for direct out-of-court negotiation be-


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tween debtors and creditors. The revision of the bank-

ruptcy code will greatly assist the debt workout pro-

cess. The resolution of internal and external debt

problems, along with the decline in interest rates, has

given Indonesia breathing space and helped rehabili-

tate corporations, which are now taking advantage

of the enhanced profitability of export industries.

Notes1The exchange rate policy includes (i) rapidly devaluatingthe rupiah, (ii) widening the intervention band, and (iii)raising transaction costs in the foreign exchange markets.

2State-vended products include staple foods (rice, sugar,and wheat flour), building materials (Portland cement),energy (electricity and petroleum products), and services(transportation fares and school tuition).

3The World Bank (1996) suggests that fiscal surplusshould be 2 percent of GDP.

4The national car policy was promulgated in PresidentialInstruction No. 2/1996, which gives Perusahaan Terbatas([PT] public limited company) Timor Putra Nasional “pio-neer” status, exempting it from paying 65 percent maxi-mum import duties for car spare parts, 35 percent maximumimport duty, and the 60 percent luxury goods sales tax.While completing its own production and assembling ca-pacity in Indonesia, the company was allowed to import45,000 built-up cars from KIA Motor Corporation of Ko-rea. To boost sales, the public sector was required to buythe cars. In return, the company promised to manufacturethe national car in stages using local components, from 20percent in the first year of its operation, to over 40 percentin the second year, and over 60 percent in the third year.Fully backed up by the Government and BI, a consortiumof 4 State-owned banks and 12 private domestic banksextended a $960-million credit to the company to build aproduction and assembly facility. PT Timor Putra is jointlyowned by Hutomo Mandala Putra, former PresidentSuharto’s youngest son, and KIA.

5The price increases announced on 4 May 1998 were asfollows: gasoline, 71 percent; kerosene, 25 percent; dieselfor cars and trucks, 58 percent; diesel for factories, 39percent; fuel for generator sets, 46 percent; electricity, 20percent; bus fares (non-air-conditioned), 67 percent; mini-

bus fares (metro mini), 50 percent; train fares (withinJakarta), 104 percent; and train fares (intercity), 50 per-cent. Due to widespread demonstrations, some of the pricehikes were reversed on 15 May.

6The open capital account system was adopted partlybecause Indonesia has no effective and efficient bureau-cracy to administer capital control.

7Since 1969, the economy has grown on average by 6-7percent a year, with an annual per capita GDP growth ofover 4 percent. Nonoil GDP, which attracted most capitalflows, grew by 7.7 percent annually in 1991-1995. Alongwith this rapid growth rate, the proportion of the popula-tion living in absolute poverty fell to 15 percent in 1990from 29 percent in 1980 and 60 percent in 1970. Growthcoincided with a major restructuring of the economy fromone highly dependent on a few primary commodities, par-ticularly oil and natural gas, to one exporting a wider rangeof products. Capital goods and raw materials make up alarge proportion of total imports. The economy’s increas-ing openness to international markets and its broadeningexport base raised its capacity to service external debt asdebt service absorbed a smaller part of total exports. More-over, diversification of nonoil exports significantly reducedthe vulnerability of export revenues to commodity priceswings.

8Through networks of ownership and interlocking busi-ness and management, all domestic private banks areclosely connected to large business conglomerates. Thecollapse of a number of large conglomerates since 1990indicates that certain sectors within them could become aburden, in part because of their strategy of being highlyleveraged, which may have been suitable in the past era ofsubsidized interest rates and highly protected domesticmarkets (Nasution 1995).

9These included banks owned by members of PresidentSuharto’s family. PT Bank Jakarta, owned by Suharto’shalf-brother, brought its case to the Administrative Courtin Jakarta and won. Bambang Trihatmojo, Suharto’s sec-ond son, simply transferred the assets and liabilities of hissuspended Bank Andromeda to Bank Alfa, the newly ac-quired bank of his widely diversified Bimantara Group.

10President Suharto received phone calls or visits from Presi-dent Bill Clinton, Prime Minister Ryutaro Hashimoto, PrimeMinister John Howard, Prime Minister Go Chok Tong, ViceMinister Anwar Ibrahim, and envoys from the EuropeanUnion (Derek Fatcher), the United States (the former VicePresident Mondale), Germany (Theo Waigel), and Japan.


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11In January 1998, Bank Internasional Indonesia and BankDagang Nasional Indonesia, two of Indonesia’s largestprivate banks, agreed to merge with three smaller banks(Bank Tiara Asia, Bank Sahid Gajah Perkasa, and BankDewa Ruci). Four banks (Bank Duta, Bank Tugu, BankUmum Nasional, and Bukopin-Bank Umum Koperasi)owned by President Suharto’s four foundations are to bemerged into one bank. The widely diversified Bakri Groupannounced its plan to merge its four banks; the TirtamasGroup, its three banks; and the Ramako Group, its twobanks. However, IBRA forced many of these large andsmall banks to close in September 1998.

12The 10 liquidated banks were Bank Surya, BankSubentra, Bank Istismarat, Bank Pelita, Bank Hokindo, BankDeka, Bank Centris, Bank Dagang Nasional Indonesia,Bank Umum Nasional, and Bank Modern.

13“Joint Statement of the Indonesian Bank Steering Com-mittee and Representatives from the Republic of Indone-sia.” Press release. 4 June 1998.

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Appendix

Chronology of Policy Responsesto Speculative Attacks,March 1997-June 1998

1997

26 March. Administrative measures concerning

foreign borrowings of commercial banks (ceilings,

market entry, net open position, reporting, uses of

credit and fines) are tightened. Banks are required

to use at least 80 percent of the external borrowings

to finance export-related activities.

16 April. The reserve requirement ratio is raised

from 3 to 5 percent.

2 July. Commercial banks are asked to stop credit

to land-based industries, except low-cost housing.

11 July. The intervention band is widened from

Rp192 (8 percent of the central rate) to Rp304 (12

percent of the central rate).

20-22 July. Bank Indonesia (BI) intervenes by

injecting $1.02 billion into the forward foreign ex-

change market.

22 July to 18 August. Discount rates of Bank

Indonesia Certificates (SBIs) are raised four times

from 7 to 30 percent per annum.

13 August. BI intervenes by injecting $500 mil-

lion in the spot foreign exchange market.

14 August. BI abandons the moving exchange

band system and replaces it with a floating system.

14 August. Public sector entities (including State-

owned enterprises) are instructed by the Minister of

Finance (MOF) to shift their deposits from (mainly

State-owned) commercial banks to BI, which with-

draws at least Rp12 trillion of liquidity from the

economy.

31 August. A limit of $5 million per customer per

bank is imposed on foreign exchange transactions,

except for investment and trading purposes.

3 and 20 September. The State budget is re-

vised and $37-billion worth of 244 public-sector-re-

lated projects, especially those requiring heavy im-

ports, are postponed. The authorities, however, reaf-

firm policies to continue the aircraft and other stra-

tegic industries under the Ministry for Research and

Technology and the national car project. Fourteen

infrastructure projects, mostly owned by members

of President Suharto’s family, are reactivated in No-

vember.

4 September. The 49 percent limit on the stake

of foreign ownership in new stock offerings on the

local stock exchanges is lifted.

17 September. Import tariffs on 153 groups of

commodities are reduced.

3 October. BI reintroduces a foreign exchange

“swap” facility for exporters and a “forward” facil-

ity to import inputs needed to produce nonoil export

products.

6 October. BI sells another $650 million in the

foreign exchange market to stabilize the external

value of the rupiah.

8 October. Widjojo Nitisastro, presidential eco-

nomic advisor and architect of economic develop-

ment during the early years of President Suharto’s

government, is empowered to take all necessary ac-

tion in coordination with the responsible agencies.

His power is revoked in January 1998.

The Government requests assistance from the

International Monetary Fund (IMF), World Bank,

and Asian Development Bank (ADB) to overcome

the currency crisis and help strengthen the finan-

cial sector.

30 October. Indonesia reaches an agreement

with IMF on a financial and economic reform pack-

age. Funding commitments amount to nearly $43 bil-

lion ($23 billion for first-line funding and nearly $20

billion for second-line resources).

First-line financial resources consist of $10 bil-

lion from IMF, $4.5 billion from the World Bank, $3.5

billion from ADB, and $5 billion from Indonesian

sources. The sources of second-line credit are bilat-

eral loans from six countries.

The IMF package has two components: (i) a

broad outline of macroeconomic policy targets (for

economic growth, inflation rate, current account


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deficit, and fiscal balance); and (ii) a broad outline

of economic reform measures covering trade, in-

vestment, financial institutions, and market infra-

structure. Effective 1 January 1998, the trade policy

reform includes elimination of the Board of National

Logistics (Badan Urusan Logistik, or Bulog) mo-

nopoly on imports of wheat, wheat flour, soy beans,

and garlic. Industry policy reform includes elimina-

tion of the local-content program for automobiles

by the year 2000.

Banking policy reform includes suspension of op-

erating licenses of 16 commercial banks (announced

on 1 November 1997) and merging of four State-

owned banks and major private banks. IMF does not

insist on closing the distressed banks as a condition

for aid, but, with negative net worth, they are dying

anyway.

17 November. President Suharto instructs the

State-owned social insurance firm (PT Jamsostek)

to deposit Rp1 trillion of its funds into State-owned

Bank Tabungan Negara (BTN) at a lower-than-pre-

vailing market rate to enable BTN to finance low-

cost housing. He also instructs PT Jamsostek to de-

posit another Rp2 trillion ($588 million) into State-

owned banks at 14 percent interest rate per annum

to enable them to provide credit at 17 percent inter-

est rate to small-scale firms.

21 November. After meeting with President

Suharto, the chairman of the Indonesian Chamber

of Commerce announces that, to ease liquidity, the

President has instructed monetary authorities to dis-

burse a $5-billion standby loan from Singapore and

ordered State-owned companies to use 1 percent

of their net profits to buy shares on the Jakarta Stock

Exchange.

31 December. The Government announces its

policy to solve the problems of State-owned banks

by (i) merging four major State banks into one single

institution by end-June 1998, (ii) privatizing State-

owned banks, (iii) allowing foreign institutions greater

equity share, and (iv) solving the banks’ bad-debt

problem.

1998

6 January. The Government presents to Parlia-

ment a draft budget for FY1999 amounting to Rp133

trillion, a 32 percent increase over the Rp101-tril-

lion budget the year before. It is based on the “bal-

anced budget” principle, which limited the budget

deficit to a level that can be financed by foreign

aid and loans, and was calculated based on unreal-

istic assumptions concerning the exchange rate

(Rp4,000/$1), annual economic growth rate (4 per-

cent), inflation rate (low), and export price of oil

($17 per barrel or $2 below the average market

price in January 1998).

15 January. In a public ceremony witnessed by

IMF Managing Director Michel Camdessus, Presi-

dent Suharto personally signs a letter of intent pledg-

ing to IMF that the Government will carry out the

50-point memorandum on economic measures. The

new agreement strengthens the IMF package signed

on 30 October 1997.

The agreement calls for a revision of the FY1999

draft budget. The deficit in the revised budget, an-

nounced on 24 January, is capped at 1 percent of

GDP. To achieve this target, the Government is re-

quired to raise its revenues and reduce its expendi-

tures by, among others, eliminating fuel and elec-

tricity subsidies. Nonbudgetary expenditures, such

as investment and reforestation funds, are to be in-

corporated into the central Government budget.

Special taxes, customs, or credit privileges, and

budgetary and extrabudgetary supports to the na-

tional car and aircraft projects are to be discontin-

ued immediately.

BI is to continue its tight monetary policy and to

strengthen the legal and supervisory framework for

banking and its administrative capability. The exist-

ing banking law is to be amended to (i) make BI an

independent institution, (ii) allow full privatization of

State-owned banks, (iii) permit greater participation

of foreign investors in ownership of domestic banks,

and (iv) authorize existing foreign banks to open more

branch offices.


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Domestic competition is to be improved by elimi-

nating cartel-like marketing arrangements in plywood,

cloves, Portland cement, paper, and steel, among oth-

ers. Bulog’s monopoly is to be limited to rice. Re-

strictions on investment and foreign trade are to be

eliminated, including on (i) foreign investment in palm

oil and on wholesale and retail trade, (ii) local con-

tent regulations, (iii) importation of new and used

ships, (iv) marketing arrangements, and (v) exports

(quotas and bans). Punitive export and local taxes

are to be abolished.

State-owned enterprises are to be restructured

and the privatization program accelerated.

To help ease the burden of the poor, community-

based programs are to be introduced and programs

for the least-developed villages expanded. Programs

to improve the environment are to be initiated.

21-24 January. To comply with the revised IMF

Standby Arrangement, on 21 January, the authorities

announce a series of measures to reform trade and

investment policies, financial institutions, and State-

owned enterprises. A revised proposed budget for

FY1999 is disclosed on 24 January. The proposed

budget is set at Rp147.2 billion, a 46 percent increase

over the 1998 budget.

27 January. To restore public confidence in the

banking system, the authorities fully guarantee de-

mand, savings, and time deposits in all banks operat-

ing in Indonesia as well as the banks’ debts (credit

received and guarantees and letters of credit issued

by them). The Government guarantee, however, ex-

cludes debts of bank owners and subordinated debts.

In two years, the guarantee will be taken over by the

soon-to-be-established Deposit Insurance Scheme.

It is also announced that the Government will estab-

lish the Indonesian Bank Restructuring Agency

(IBRA), an independent institution under the aus-

pices of MOF. IBRA has two main functions: (i)

supervise the banks in need of restructuring and

oversee the restructuring process, and (ii) manage

the assets it acquires in the course of bank restruc-

turing.

The Government proposes to temporarily freeze

servicing corporate external debts, including finan-

cial loans (bank loans, bonds, commercial paper, and

similar debt instruments) and excluding trade-related

debts. It made it clear that public financing, guaran-

tees, or subsidies will not be used to bail out unguar-

anteed creditors. Private sector default is to be per-

mitted, even in the financial sector. A steering com-

mittee of creditors and a contact committee of debt-

ors is to be formed to resolve the corporate debt

problem through voluntary agreements between bor-

rowers and lenders. The steering committee is to

consist of senior international bankers from the main

creditors’ countries while the contact committee is

to be composed of executives from 228 local indebted

companies.

13 February. Emerging from a meeting with Presi-

dent Suharto, Steven Hanke, a US economist and

newly appointed adviser to the President, declares

that the Indonesian leader is in favor of a currency

board that pegs the rupiah to the dollar. IMF and

major economic powers and markets strongly disap-

prove because (i) Indonesia’s banking system is in

distress, (ii) the share of the nontraded sector in the

economy is large, and (iii) the country’s legal and

accounting systems are weak.

17 February. Sudradjad Djiwandono is fired as

BI governor in the face of a standoff with IMF. Presi-

dent Suharto calls the IMF program unconstitutional.

20 February. To restore fading confidence in the

banking system and macroeconomic management,

President Suharto personally decides to return all the

money blocked in the 16 banks liquidated on 1 No-

vember 1997, amounting to Rp3.1 trillion. Minister

of Finance Marie Muhammad says that the funds

for this program are to come from the central bank,

to be repaid by the Government over 10 years.

5 March. Following intense pressure from IMF,

US, Japan, and other members of the Group of Seven,

Indonesia reaffirms its commitment to the IMF re-

forms and suspends the plan to implement the con-

troversial currency board system.


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Government figures show that the economy is

on the brink of hyperinflation and growth decelera-

tion. Month-to-month inflation rose to 12.76 per-

cent in February, compared to a 6.88 percent rise

in January, with the year-to-year rate of around 31.74

percent.

10 March. President Suharto is reelected by the

People’s Consultative Assembly for a seventh five-

year term ending in 2003. Baharudin Jusuf Habibie,

former research and technology minister, is Vice

President. Habibie has a reputation as a big spender,

and his ambitious “high tech” projects are the main

targets of the IMF reform package. (In February,

IMF First Deputy Managing Director Stanley Fischer

implicitly criticized Habibie’s candidacy.)

15 March. President Suharto appoints to a new

Cabinet his eldest daughter, a business associate and

golf partner, and top officials linked to his family’s

businesses, ignoring urgent calls from the people,

world leaders, and IMF to institute reforms. The eco-

nomic crisis deepens.

8 April. Indonesia reaches an agreement with

IMF on a new package of economic reforms with

specific targets and timetable, which IMF is to watch

closely to ensure compliance. The Government calls

the new agreement “the IMF Plus” as it is based on

Mexico’s Ficorca program and includes the IMF

commitment to help solve the $72.5 billion private

sector external debt.

8-12 May. Violent demonstrations, social unrest,

riots, arson, and looting erupt in Medan, Solo, Jakarta,

and other cities after sharp hikes in electricity, fuel,

and transport prices. Joined by other sectors of soci-

ety, students demand the resignation of President

Suharto and the end of corruption, collusion, and

nepotism, which are the roots of the economic crisis.

Social unrest escalates in Jakarta after security forces

shoot and kill six students during protests around

Trisakti University in Jakarta on 12 May. In the fol-

lowing days, rioters loot and set fire to cars, banks,

shops, and shopping malls. In Jakarta alone, nearly

1,500 people die in the chaos. Expatriates and afflu-

ent Indonesians (mainly ethnic Chinese) are evacu-

ated from Jakarta. All outbound flights are full on 15

May, and airport hotels fully booked.

15 May. Because of the political and economic

chaos, President Suharto cuts short his state visit to

Cairo, Egypt, where he is attending a summit meet-

ing of 15 developing countries. Upon his return to

Jakarta, President Suharto promises to form a re-

form committee and hold early presidential elections

in which he will not run. The people demand his im-

mediate resignation and the return to the country of

his family assets, worth an estimated $40 billion.

21 May. President Suharto resigns after 32 years

as the head of the world’s fourth most-populous na-

tion. Vice President Habibie, his protégé, immedi-

ately takes the presidential oath of office. Suharto

says Habibie is to serve until 2003. Many analysts,

including his Cabinet ministers, predict that he may

be merely a stop-gap successor. In response to do-

mestic and international pressure, President Habibie

promises to call a special session of the Parliament

in late 1998 or early 1999 to approve changes in elec-

toral laws.

23 May. President Habibie swears in his Cabi-

net. During the Cabinet’s first meeting, he pledges to

implement the IMF program and bring Indonesia back

from the brink of economic collapse. He also prom-

ises to accelerate bank restructuring under IBRA

supervision and to give BI independence in exercis-

ing monetary policy, including on interest rates and

foreign exchange management.

29 May. The IMF representative returns to

Jakarta to review economic and political conditions.

Because of the uncertainty, IMF suspends disburse-

ments of a $10-billion balance-of-payments loan,

which is the central part of the rescue package. The

World Bank and ADB also postpone loans to Indo-

nesia. Private talks with international creditors are

delayed.

4 June. Indonesia reaches an agreement with re-

spect to a comprehensive program, based on the

Mexican Ficorca program, to address the private


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sector’s external debt. The scheme is to be adminis-

tered by the Indonesian Debt Restructuring Agency

(INDRA), a Government institution under BI. INDRA

provides “exchange risk protection and assurance

as to the availability of foreign exchange to private

debtors that agree with their creditors to restructure

their external debt for a period of eight years, with

three years of grace during which no principal will

be payable.” This delays pressure on the balance of

payments, but the exchange rate subsidy would raise

contingency liabilities of the Government and public

budget.

Documents

Recent Issues in the Management of Macroeconomic Policies ... · PDF fileMacroeconomic Policy ... ten quoted as the indicators of sound ... ISSUES IN THE MANAGEMENT OF MACROECONOMIC