NBER Project on Exchange Rate Crises in Emerging Market Countries: Indonesia


A Report on the Fifth Country Meeting of the NBER Project on Exchange Rate Crisis in Emerging Market Countries

John McHale
September 15, 2000

Project Directors: Martin Feldstein and Jeffrey Frankel
Program Chairmen: Simon Johnson and Steve Radelet

Indonesia was the subject of the fifth country-specific meeting of the NBER project on exchange rate crises. The Indonesian crisis of 1997-98 provides a fascinating case study, if for no other reason than the subsequent economic contraction has been deeper there than in any of the other crisis afflicted countries.  Indonesian Real GDP fell by a staggering 13.7 percent in 1998, followed by a small further decline in 1999.  Although Indonesia appears to have returned to growth in 2000, it has not had the rapid rebound seen in Korea and (to a lesser extent) in Thailand. 

The depth of the crisis in Indonesia has come as a surprise to many observers.  Indicators of macroeconomic imbalance were worse in Thailand leading up to the crisis, and both Korea and Thailand shared the financial sector weaknesses that made Indonesia vulnerable.  Korea also faced political uncertainty at the outset of its crisis; but, unlike Indonesia, managed to put together a package of reforms that restored the confidence of foreign investors.  Why did Indonesia suffer such a deep crisis? 

To better understand the crisis and slow recovery the organizers assembled a group of experts at the Royal Sonesta Hotel in Cambridge on September 15, 2000.  Those invited included present and former high-ranking officials from the Indonesian government, officials from the international financial institutions, representatives of the US Treasury and the Japanese Ministry of Finance, officials from leading financial institutions, and academic experts. 

The program was divided into four sessions, with the format being a set of short remarks by four or five distinguished panelists, followed by general discussion.  The sessions followed the chronology of the crisis, starting with developments prior to 1997, and then moving to the macroeconomic policy response in the latter half of 1997, the problems of banking sector, and finally the attempts at recovery.  This report provides an outline of the panelists’ comments and a summary of the general discussions.

Session 1: Liberalization and Growth Before 1997

Jeffery Frankel, Harvard University and NBER

Iwan Azis, Cornell University
Joseph Stern, Harvard University
Swati Ghosh, World Bank
Rino Effendi, Danareksa, Indonesia

Iwan Azis comments addressed the macro policy stance, the external environment, and issue of reform sequencing.  On macro policy before the crisis, Azis said that monetary policy had been broadly appropriate.  He added that confidence in the Indonesian economy—both domestic and foreign—led to substantial investment and an associated import surge.  The large capital inflows did not, however, have a big impact on the real exchange rate, though there were some real appreciation pressures.  More important in Azis’s view was the rise in short-term debt, though at the time there was little reason to be concerned about the Indonesian economy.  He added that the structural weaknesses in the banking sector and elsewhere—which he noted are often attributed to cronyism, corruption, and nepotism—were “annoying but not lethal.”  

On the external environment, Azis emphasized the role of exchange rate appreciation in competitor countries in increasing the flow of capital to Indonesia.  He also stressed how low Japanese interest rates led Japanese banks to look for alternative opportunities. 

Turning to sequencing, Azis reminded the group of the standard advice: first stabilization, then trade liberalization, followed by financial sector liberalization, and only then liberalizing the capital account.  Indonesia’s course, he offered, was practically the opposite.  But he disagreed that the country’s subsequent problems could be blamed on this.  First, the government needed to exploit natural resources, and foreign capital was needed for this.  Second, the phenomenon of portfolio capital flows to emerging market economies—which are subject to sudden reversal—was not really an issue in the 1980s.  And finally, though admitting that alternative sequences could have led to better macro performance, in terms of broader social objectives (that included, for example, income distribution) the overall impact was not so bad. 

In a similar vein, Joseph Stern observed that the macro policies—despite not being fully consistent—did work well for a long time.  This makes it hard to argue now that they were not the right ones.  Eventually, Stern added, the policies became more inconsistent due to the growing problem of “crony capitalism,” which made it “harder for the system to adjust.”  He reminded the audience of the achievements of the Indonesian economy over the 20-year period before the crisis: a huge increase in per capital income; inflation down from very high levels to around 10 percent; a large expansion in food supply; growth in rural incomes together with more stable food prices; a massive structural shift towards industry; a huge expansion in manufacturing exports; and a sharp decline in poverty.  He added that all this was achieved without a serious deterioration in income distribution. 

What changed?  In the early 1990s, the influence of the President’s family and those connected with them increased.  This led to distortions.  The protection of one sector led to calls for protection in other sectors that were forced to pay high prices.  Added to that, policy makers were unable to push for more liberalization and openness.  It also became harder to supervise the banking system. 

Stern said the macroeconomic factors alone would not have been enough to cause a double-digit decline in GDP.  Two additional factors played a central role.  First the aforementioned problems with the banking system.  Prudential rules were lacking.  And lacking political support the central bank did not have the authority to enforce what rules did exist.  But he added that if Indonesia had not deregulated the banking system there would have been a continued monopoly for state banks.  As it turned out, these banks were the “worst offenders,” he said.  So things would have been even worse if deregulation had not taken place. 

The second factor was the essentially fixed exchange rate (though adjustments were made to compensate for inflation differentials).  Because of the apparent predictability of the exchange rate economic actors felt that hedging was unnecessary.  And favorable interest differentials encouraged borrowing abroad, without hedging the exchange rate risk. 

Stern summed up by saying that Indonesia initially had a reasonably sound system, which worked well as long as policy makers could make the necessary adjustments.  In the end, however, those adjustments could not be made.

Swati Ghosh continued on the theme of the rise in Indonesia’s vulnerability.  In her view, the caused of the vulnerability was the interaction of capital inflows, macro polices and weak financial institutions.  The capital flows, which rose strongly after 1990 despite the Indonesian capital account having been open for decades, responded to reforms and changes in global markets.  In fact Indonesia’s “strong policy mix” encouraged unhedged flows.  This mix included the sterilization of inflows (which kept interest rates high); a pro-cyclical fiscal policy; and, as Stern had emphasized, a fixed exchange rate.  These policies contributed to the accumulation of short-term liabilities.

On the banking side, foreign and domestic funds drove an expansion in lending.  Notwithstanding the improvement in prudential regulations, the banks had little incentive to carefully examine their risk profiles.  Smaller banks tended to be crowded out of the lending market by their larger competitors.  And lending to risky sectors such as property sector increased, leading, in turn, to an inflation of asset prices.  The combined impact was a large increase in financial sector vulnerability

Rino Agung Effendi dissented from the financial sector centered story that his fellow panelists had given.  He said that analysts are still viewing Indonesia’s “national theme” of CCN (Corruption, Collusion, and Nepotism) as a rhetoric that has little to do with the crisis.  The common practice of demanding a fat fee (of thousands to billions of dollars) for the personal gains of both business owners and bureaucrats in virtually all government-related projects is perceived as an exception rather than the rule.  The pervasive abuse (and structural misuse) of power and public funds for personal wealth were grossly overlooked by reducing their significance to an issue of inefficiency.  The exorbitant mark-up of prices over costs, improperly termed as rent-seeking, which was the basis for securing and extorting bank loans, deserves much greater attention as this issue was not the exception, but the rule.

Fair business practices without collusion and corruption were the exception during the economic boom that ended with a bursting of the bubble.  With or without the contagion from Thailand or elsewhere, the bubble was bound to burst after more than three decades of fraudulent and unhealthy business practices.  The normal practice of enriching oneself at the expense of others- by means of over-pricing and over-invoicing in the procurement of goods and services- is systemic and deep rooted.  “We developed  and nurtured the expertise of blowing up the value of our assets or reducing the quality of our products, he said.  The practice of cheating others translated into habitual and routine activities and spread rapidly throughout the country to become a “culture,” with an increasing number of people addicted to lying to others or taking advantage of the country’s legal laxity and loopholes.  With this self-cheating attitude adopted nationwide,  Indonesians did not trust the quality of their products, their system, and their own people, he said.  Indonesia’s susceptibility to a crisis rose astronomically.  Unfortunately, this vulnerability was masked by macroeconomic data that continued to report strong economic progress.  Indonesians were all astounded by the crisis as it contradicted the rosy macroeconomic outlook and caused imponderable casualties and irreparable damage.

Effendi argued that the crisis is not just a macroeconomic problem.  Standard macroeconomic teaching treats these commonplace malpractices as an exception that goes beyond the boundary of economics.  It is no wonder that the problem of massive misappropriations of public funds is disguised under the term “high cost economy,” he said.  Ubiquitous violations of almost all regulations, plus legal and professionally legalized business malpractices in the economy as well as crafty financial engineering, are incorrectly phrased as an issue of transparency and accountability or poor corporate practice.  The accelerated pace of extorting public resources and funds for personal benefits through widespread mark-up practices has a hazardous built-in tendency to generate a larger scale of corruption, collusion and nepotism with systematic risks at work.  This self-defeating system continued to feed upon itself as lies were camouflaged by bigger lies with the aid of foreign loans to blind the eyes of even the most internationally reputed economists from abroad and at home.  The influx of offshore funds, both official and private capitals, with the arrival of official debts endorsing the implicit guarantee for private loans to come, spurred growth but disguised the rapid spreading of bribery and felony.  Compliments for Indonesia’s economic success story described in the World Bank and IMF reports, played a pivotal role in preventing the mushrooming CCN from being widely exposed, understood, and recognized not as an exception, but as a governing rule for doing business in Indonesia.  As regulations were broadly tailor-made, legal malpractices of profiting from Indonesia’s deficient and leaky system by impoverishing people and causing the system to eventually collapse are by no means an exception.  The speed by which the system collapsed, and the depth and severity of the crisis, as well as Indonesia’s subsequent slow recovery, are self-explanatory, he concluded. 

General Discussion

Steve Radelet (Harvard University, currently on leave with the US Treasury) opened the discussion with a warning on the danger of forgetting about the common elements of the problems across countries in region.  When the focus is on specific countries, “we tend to forget that much of the fault lies with the international financial markets,” he said.  Bankers were “falling over each other to lend.”  He then asked about the impact of limits on external borrowing after 1991.  These limits applied to the government, the central bank, state enterprises, and banks, but not to the private sector.  He wondered how this contributed to the crisis, adding that the regulations led private sector corporates to borrow offshore.

Anoop Singh (IMF) suggested that it would help if the crisis were looked at from a fiscal standpoint.  He said that Indonesia had a balanced budget rule, but contingent liabilities were building up.  There was also a growth in off-budget accounts, leading to a fall in the revenue base. 

Recalling a distinction that has been made throughout this NBER project, Nouriel Roubini (New York University) compared the “run story” to the “structural weaknesses story.”  Based on what he had heard, all indications are of structural fragility in the financial and corporate sectors. David Cole observed that the focus had been on the macroeconomic conditions, but it was the political system that was not viable.  This led to the structural weaknesses that Roubini listed.  Foreigners, he said, believed that the economy and political system would eventually face a crisis—but not so fast as actually happened.  They felt there would be advance warning and time to get out before the crisis hit—or at least be bailed out if you couldn’t get out. 

Jim Hansen (World Bank) offered that that the sequencing issue had not been phrased well.  He observed that the initial financial opening had taken place too long ago to be relevant as a cause of the crisis.  Instead, the 1989 liberalization might have been more to blame.  On the other hand, this liberalization may have allowed the people who could make the best use of the money to get it.  An even more important issue, he thinks, is the prevalence of offshore credit.  He then asked why, if everybody was so confident, was the borrowing so short term?; why there was such a large spread between dollar and domestic currency deposits?; and, if people were so confident about the exchange rate, why were the differences not arbitraged away?  Lastly, he pointed out that “off-budget accounts” actually fell in the years before the crisis. 

Haruhiko Karoda (Ministry of Finance, Japan) questioned the wisdom of blaming the private sector.  They were, after all, entitled to exploit opportunities.  “So who should be blamed?” he asked.  His answer was the public sector, which did not foresee the crisis and take appropriate measures.  But he also placed blame on the Japanese and US governments, the IMF, the World Bank, among others.  So what could have been done?  He argued that a need existed for some sort of capital inflow control.  This could have reduced vulnerability; though he stressed that this was not the only measure that needed to be taken. 

John Bresnan (Columbia University) referred to the speculation about whether Suharto would stand for reelection.  In the eyes of the military, Suharto was showing signs of weakness.  In his view, the “political weight against the Suharto regime” was building up from at least 1993.

Anwar Nasution (Bank Indonesia) said that the high rate of growth was driven by the non-traded sector.  There was growth in labor-intensive manufacturing, but this was low valued-added activity given the high use of imported inputs.  He concluded that despite the impressive macro indicators, there were underlying weaknesses.

Barry Johnston (IMF) pointed out that Indonesia did impose controls on capital inflows into the banking system.  But he asked why the corporations were allowed to borrow abroad.  “Were they,” he asked, “connected to the banks?”  “Was there an assumption that they would be bailed out?” 

Bambang Subianto questioned if macroeconomic indicators can really give a signal of the vulnerability of a country.  Responding to a question from Martin Feldstein, he also said that an effort had been made to identify a list of foreign debtors.  He said a list exists, but it might not be complete.  Denis Flannery (Lehman Brothers) said that knowing who the debtors are is very important for devising the right response.  Steve Radelet said that there were BIS data available on what was owed to international banks.  Drawing on experience with Latin American Brady bonds, Jim Hansen (World Bank) observed that it was hard to discover who owes what to whom.  He said that, though incomplete, the BIS numbers turned out not to be so bad.  Martin Feldstein responded that back in the 1980s measures were taken by the Institute for International Finance (IIF) to calculate what the exposure was.  He asked why measures were not taken to discover the exposure when the IIF numbers were not available.  Lloyd Kenward (formerly World Bank) said we did know about the levels of short-term debt, adding that this raises the question of why something wasn’t done.  He said that Indonesians are very adept at getting around regulations.  Trying to impose capital controls now would be largely ineffectual, leading to fertile ground for more corruption.

Timothy Lane (IMF) referred to a Fund study examining whether the institution had anticipated the crises in Asia and warned the authorities beforehand.  By and large, he said, while the Fund had been aware of many of the weaknesses it had not recognized their urgency.  This is part of the motivation for the Financial Sector Stability Assessments that the IMF is now doing. 

Iwan Azis responded to the discussion with three points.  First, the macro policies were not primarily to blame.  Even if the off-budget balance grew, it was not a big problem.  Second, Indonesia has long lists of regulations—the problem is enforcement.  He asked how effective regulations are given the social and political conditions.  Third he said people knew about the private sector debt.  But these numbers tended to be ignored when the macroeconomic indicators looked good. 

Joseph Stern returned to the issue of the labor-intensive sector noting the problem was not that exports were labor intensive, but rather the lack of backward linkages to increase value added.  There were few incentives to become a supplier to exporters.  Turning to the issue of the private sector debt, he recalled that it was not considered a problem prior to the crisis.  It was not understood that “private debt is not truly private.”  Finally he said that there was real pride in the open capital account, and observed that any attempt to get people to report on capital flows was seen as undermining this achievement. 

Swati Ghosh stressed that capital controls did not work in Indonesia.  Corporate borrowing provided a way around the controls, and led to a cycle of borrowing, rising collateral value, supporting yet more borrowing. 

Session 2: Macroeconomic Policy in Fall, 1997

Simon Johnson, MIT

J. Soedradjad Djwandono, formerly Governor of Bank Indonesia
David Lipton, Moore Capital Strategy Group
Josh Felman, IMF
Steve Radelet, Harvard University, Currently on leave at the US Treasury

J. Soedradjad Djiwandono outlined how the early policy response (prior to the IMF rescue) centered on the exchange rate.  As the crisis developed in early July 1997, the policy was to have a managed float with “creeping depreciation.”  But as pressures mounted, the response was to widen the band.  The initial analyst response was positive, but the satisfaction only lasted for a matter of days.  Djiwandono noted that previous attempts to relieve pressure on the rupiah had been solved by widening the band.  This time, however, the problems were much bigger, and this policy response did not work. 

By August of 1997 the banking sector was already distressed, and to restore confidence the IMF was “invited to come.”  Two problems loomed large: corporate sector weakness and financial sector weakness.  The position of the IMF at the time was that the private sector must not be bailed out, Dajiwandono said, though he added that they later became more involved in that process.  The banking sector “restructuring” started with the closing of banks.  Reflecting the debate on the wisdom of these closures, he put the question to the participants “Were too many closed or too few?”  He closed by highlighting the important distinction between the “closing” and “freezing” of banks, and by stressing the role of banks in the payments system.

David Lipton offered a perspective on the Indonesian crisis of someone who was at the US Treasury Department at the time.  He recalled that earlier in the year (at the Hong Kong meetings) there had not been a sense that the country was heading for crisis.  Things had changed by October.  In early November, there had been a major loss of confidence among Indonesian businesses, leading to substantial capital outflows.  There was also deep concern about balance sheet solvency despite reasonably impressive macroeconomic numbers.  But there was resistance from Suharto, and a denial of the depth of the problem.  As the program was put together in early November the question that Nouriel Roubini had posed earlier in the day—bank run or major structural weakness—was addressed.

The main elements of the program were: introduce a flexible exchange rate with an intervention rule; prevent the strong fiscal position from eroding; strengthen the banks; and implement various “novel” structural measures.  Up until February, the exchange rate policy was not consistent with the interest rate and credit policies being pursued.  Turning to fiscal policy, Lipton expressed the view that the budget was never the most important policy lever for dealing with the crisis.  On banking policy, he said that the bank closures were not done well.  The problem, however, was not that banks were closed, but that people began to wonder if more closures were to come; expectations fueled fueled further by capital flight.  The structural measures were, he admitted, “somewhat atypical.”  They were designed to pare back crony capitalism and to signal that things were changing.  They were, he added, “designed to have an important impact on confidence.”

Lipton went on to express the view that a lack of political leadership was at the heart of Indonesia’s crisis.  “As economists,” he said, “we have to think about how you prescribe policies in the face of a lack of political will to carry them out.”

Moving beyond politics, Lipton said that the monetary and exchange rate regime played a central role in the crisis.  The IMF money was to help cushion the economy while confidence was restored, but this turned out to be an invitation to the “cronies” to “borrow money in the morning and buy foreign exchange in the afternoon.”  Later on the Suharto government did improve the policy by moving to a flexible exchange rate with no intervention.  The program, which was kept in place after Suharto was swept from power, has faced problems of implementation.  Lipton concluded by saying that the key question going forward is how Indonesia is going to deal with the debt problem

Giving an IMF perspective, Josh Felman opened with two questions: “What was the initial Program?”  And “What went wrong?”  Defending the initial program, he said that the choices were reasonable given the options that were available at the time.  He reminded the participants how good the macro numbers looked prior to the crisis.  He urged that the attack in 1997 seemed to be a problem of pure contagion.  For this reason, it was believed that by giving a sizable line of credit, investors would be reassured. 

Turning to the banking sector and the call to close sixteen banks, Felman said the problems turned out to be more serious than known at the time.  He added that if more had been known, more would have been done.

The truly critical failure, however, “was the failure of Suharto to rise to the occasion,” he said. As Suharto failed to implement the promised measures, and then fell seriously ill, the well-connected rushed to get their money out, causing the exchange rate to collapse. 

Felman closed by considering the lessons learned.  First, he said that sound policy requires sound information. Since you cannot close banks merely on suspicions, better information is needed.  Second, Indonesia needs to have a much better system of financial supervision.  He noted here that the situation is improving.  Lastly, and most generally, he said that the fate of economies depends on politics as much as it does policies.

Steve Radelet, who previously was critical of the international policy response to the Indonesian crisis, emphasized strongly that his comments should not be attributed to the Treasury Department.  His opening remark was that he does not know of anyone who believes the mere panic story—again with reference to the Roubini distinction from earlier in the morning. The distinction is between those who believe that the crisis was due purely to structural weaknesses in the affected economies, and those who believe it was structural weaknesses combined with financial panic. For the record, he said that in his work with Jeffrey Sachs, he pointed to the structural weaknesses in the Indonesian economy.  He then asked, “When do structural weaknesses lead to a panic?”  His answer for the Indonesian panic is that there was a shortage of foreign exchange reserves relative to the short-term liabilities, and added that “they did not deserve a crisis as deep as the one they got.” 

Continuing with his questioning of the policy response, Radelet noted that there had been a huge economic contraction due to the outflow of capital.  “Should there have been a fiscal and monetary tightening on top of that?” he asked.  Interest rates had to go up but the question is “how much?”  There is a tradeoff between the extent of the exchange rate depreciation and the impact on the balance sheets of the financial sector.

Turning to the bank closures, he pointed out that unlike Thailand and Korea deposit institutions were affected.  He asked with some exasperation, “Do you close banks in the middle of a panic?”  The bank closures were meant to be a signal to foreign investors, but there wasn’t a detailed plan for restructuring the financial system.  It would have been better, he concluded, to design a more comprehensive financial restructuring program, even if that would have taken a few more weeks.  Radelet’s final comment was to question the accuracy of the claims about the size of the credit line give to Indonesia.  He said that the original Fund program had planned to disperse just $3 billion in the face of a much larger stock of short-term debt. 

General Discussion

Tim Lane (IMF) opened the discussion by saying he agreed with much of what Steve Radelet had said, but wanted to address a few points.  He noted that, while the initial attempt to hold the line on the fiscal deficit was recognized in early 1998 to have been mistaken, the IMF had struggled during the rest of 1998 to get a fiscal expansion, given the conservative tradition of Indonesian public finance.  On the bank closures, he asked what was the alternative was to closing banks in the middle of a crisis: if insolvent banks were left open, this could mean using international money to cover these banks’ ever-deepening losses.  On the interest rate policy question, he recalled that both interest rate increases and exchange rate depreciations had damaging effects on the banking system so the authorities and the Fund had tried to steer a middle path between two unattractive alternatives.

Gustav Papenek (BIDE and Boston University) pointed out how the government had systematically blamed the Chinese community.  This accelerated the flight of Chinese community capital.  When a big inflow turns into a big outflow there will be a big impact, Papenek remarked.  He added that the Chinese community wanted to get their money out, regardless of the exchange rate and the interest rate.  He added that the impact on the population should not be forgotten.  There were sharp declines in real wages—and the resulting disturbances led to still greater capital flight. 

Douglas Diamond (University of Chicago) said he wanted to say a few nice things about short-term debt.  You will be able to raise more money if you don’t limit yourself to long-term debt.  To improve things, he added, improvements to the legal system are needed to increase the supply of long-term debt.

Ernest Stern (J.P. Morgan) pointed out that long term bank lending is a diminishing asset class around the world.  Long term debt financing increasingly requires access to the public capital markets.  Indonesia had barely used this market.  Moreover, while short term debt serves important purposes, using it to finance long term investments or budget deficits, exposes the borrower to a major maturity mismatch and roll-over-risks—precisely one of the causes of the crisis in Asia.  On the issue of bank closings, David Cole commented that closing the sixteen banks reduced the drain of central bank funding for them, but other banks that were kept open became a much heavier drain.  He said that the message went out that the central bank would provide the funds to cover reserve deficiencies for most if not all banks, leading to a deep moral hazard problem.  In his view, banks that were heavy borrowers from the central bank  needed close monitoring, but no serious attempt was made until much later in the crisis. 

Shang-Jin Wei (Harvard University and NBER) responded to the claim that interest rates needed to be raised to increase the cost of capital flight.  (Rudi Dornbusch had made this argument during his dinner remarks the previous evening.)  Wei said that capital controls are an alternative way of increasing the cost of capital flight, an alternative that could stem the flows in a cheaper way.  Dornbusch responded that it would be the well connected that would get their hands on whatever funds were available.

Andres Velasco (New York University and NBER) said that even with high interest rates some people get cheap credits. Charles Calomiris (Colombia University) noted that it is counterproductive to have depreciation when you have a large foreign debt. He said that a better strategy would have been a nationalization of the debt and a degree of default.

Anwar Nasution (Bank Indonesia) observed that the bank closures were badly managed.  He added that the lesson from Korea and Thailand was that blanket guarantees were not appropriate.  Commenting on other issues, he said that the structural policies Lipton had referred to were mostly unrelated to the currency and financial crisis.  On the capital controls issue raised by Wei, he said that some inflow controls could have been implemented before the crisis struck. 

On the bank closure question, Ed Kane (Boston College and NBER) emphasized that it is prompt bank recapitalization that matters. It is, of course, socially wasteful to close banks that are viable.  He added, however, that the shareholder claims must be “moved out of the way” to reduce incentives to strip assets and support long shot investments.

David Hale said that the IMF’s insistence on bank closures was appropriate in principle, but when people saw banks controlled by the Suharto children at risk, it led to a complete reevaluation of the political system, and to capital flight.  The foreign bankers who made the loans did so on the assumption of the political system continuing.  He said there is need to understand the sociology of the financial system, taking due note of the signal being sent out to the people controlling the money. 

Lloyd Kenward (formerly of the World Bank) said that the size of the package was confusing at the time—no one really knew how big it was.  There was very little up front money, and part of that was spent in the early intervention.  Analysts felt that there wasn’t enough, he concluded. 

J. Soedradjad Djiwandono responded to some of the points raised.  He said that in 1996 there had been talks about a “Tobin tax” to slow the capital inflows.  He also observed that privatization had actually caused some of the cronyism.

David Lipton said that liquidity credits were providing support for the banks; but it went beyond this—“funds were being given to Suharto’s cronies at low rates.”  It was, he said, monetary creation.  Responding to Velasco’s point, he agreed that Suharto could indeed have subverted any policy.  He added that Mexico was on their minds as they formulated the policy response.  The reason for the success of the Mexico policy was twofold: there was a lot of money on the table; and they communicated their policy.  Responding to Calomiris, he said that the corporate debt did need to be dealt with, adding that the corporations should have negotiated with their foreign creditors. 

Josh Felman said that it was tempting to criticize the Indonesian program.  It did, after all, go wrong.  But he asked it was it the fault of the policies.  The information at the time was that the problems were confined to 5 percent of the banking system.  It also felt that much of the criticism was “ahistorical.”  One example is the claim that the liquidity credits allowed asset stripping.  Felman said that it was only after Suharto fell that asset stripping and capital flight took place.  The final “fallacy” that Felman responded to is the claim that the funds were not sufficient.  If things had gone well on the political side it should have been enough, he concluded.

Steve Radelet started his response by taking up Felman’s final point.  “Was the money there,” he asked, answering “Yes, but it wasn’t going to be released anytime soon.”  Having money available over three years, he added, is not enough when the money is going out the door.  On the question of the bank closures, he said that a lot of people questioned their wisdom at the time, so it isn’t an issue of wisdom with hindsight.  He recalled that there was great uncertainty about which banks would be closed, which added to the capital flight.  Finally, he said that another instrument was needed to improve the tradeoff between the exchange rate and the interest rate.  He listed some options: capital controls, debt standstills, and debt rollovers.   

Session 3: Banking (And Broader Issues of Institutions)

Steve Radelet (Harvard University, Currently on leave at the US Treasury)

Bambang Subianto, formerly Indonesian Ministry of Finance
Lloyd kenward, formerly World Bank
Yung Chul Park, University of Korea
Ernest Stern, J.P. Morgan

Bambang Subianto, former Indonesian Minister of Finance, commented first on the controversial bank closings in the midst of the crisis.  He reminded the group that the first reaction was positive, but sentiment changed on the announcement of the takeover of a private bank by one of Suharto’s sons.  Turning to issues of poor corporate governance in the financial sector, he provided the example of credit being channeled to a group to build a petrochemical complex with a value much lower than the money invested.  He went on to discuss how project cost “mark ups” were considered normal behavior, giving the example of an electricity project that cost $2.4 billion—twice what assessments indicated it should have cost. 

Lloyd Kenward, drawing on his experience in Jakarta from 1994 to 1998, said that there is now a broad consensus that the bank closures—or at least the manner in which they were executed-- in 1997 were mistaken.  He added, however, that though he was not consulted he probably would have endorsed them at the time.  He asked: If you can’t close them when times are good; and you can’t close them when times are bad; then when?  And added that, in Suharto’s Indonesia, you had to take your chances [for reform] when you could.  Nonetheless, Kenward believes the closures were badly managed. 

On the question of corporate governance, Kenward emphasized the inadequacies of risk analysis.  He asked if the off shore borrowing of the corporates was sufficiently understood.  He also stressed that it was well known that accounting procedures were questionable. 

On a more positive note, Kenward said that contrary to popular opinion a number of attempts were bad to improve the financial behavior of the corporate sector.  Indicative ceilings on off shore borrowings by private corporations were put in place.  Limits were put on the foreign exchange positions of banks, but this had the unintended consequence of increasing corporate sector borrowing.  Some attempts to “bail in” private creditors were tried and failed.

Kenward asked, “What would have worked?”  His answer, re-starting  deregulation.  This would have restored confidence without highly contractionary monetary and fiscal policies. 

Kenward closed by pointing to the institutional weakness prevalent in Indonesia.  He said Suharto’s Indonesia was characterized by one extremely strong institution—the Presidency—but all other institutions were weak

Yung Chul Park, who has recently been examining financial restructuring in four Asian economies for the Asian Development Bank, said emphatically that the bank closures were a mistake, adding that 68 banks have now been closed.  He said that the extent of the non-performing loans (NPLs) depends on the performance of the economy.  When a country is in crisis, every institution is unsound, and it is not possible to distinguish the good from the bad.  Park blames the IMF and World Bank for wanting to fundamentally reform the Indonesian economy into a modern economy in a short time. 

Looking forward, Park asked what should be done now.  He stressed that a substantial portion of the foreign debt should be written off.  Without doing something about the corporate debt, he said, the banks will remain in a difficult situation, limiting credit growth and hampering recovery.  He believes that, at this stage, Indonesia does not have the resources or institutions to push ahead with the reforms the international institutions are asking of them.  Instead, Indonesia should be left alone.  They have established all sorts of market supporting institutions; but the western reforms are not taking hold.  Since things can’t get any worse, he concluded, what they need is growth, relying on the market supporting institutions that have been created. 

Ernest Stern opened by saying he agreed with those who said there is no real alternative to the IMF’s policy of bank closures in Indonesia.  Global experience tells us that any initial estimate of the size of bad debts tends to increase over time.  The problems are not created by the closure of banks.  Transparency, inadequate accounting standards and weak supervision, he continued, was a big part of the problem—“we all knew of the problems of nepotism, etc., but no one knew of the extent of it.”  In fact, much of the banking system was insolvent by this time. Investing new capital into such weak and badly managed banks was not a good alternative.  However, implementation of the closures could have been managed better, with more help given to depositors. 

Turning to the current situation, Stern said that the bank recapitalization is now almost complete.  There is, however, a long way to go before the banks are “in proper shape.”  In Stern’s view, the actions taken to date are only a start to building an adequate banking system.  The recapitalization needs to be followed by reprivatization. There has been little progress on the disposition of the non-performing assests. There is limited interest by buyers, concerned about the political situation and concern in IBRA that selling these assets at distress prices will prove politically unacceptable.  The banks that have been recapitalized with “recapitalization bonds” appear “happy to stay with this asset base and not to lend,” he said.  For banks to be attractive as investments to new owners, including foreign investors, they need to be able to invest in a restructured private sector.  This requires both more effective asset disposition and restructuring of outstanding corporate debt. 

In closing, Stern expressed the belief that the institutional weaknesses do not explain the onset of crises in the Asian economies, in the sense of being the trigger. Without the Thai crisis, the crises in Korea and Indonesia might not have happened. But neither would the efforts now underway to get rid of the structural weaknesses which eventually would have created serious problems.  He noted that Korea had the largest support program, but that only a fraction of it was used.  Korea, he said, was seen to be moving aggressively to address its institutional weakness and this restored market confidence quickly.

General Discussion

Lou Wells (Harvard University) said the Bambang Subianto was kind in not pointing out that foreigners were involved in many of the bad deals he mentioned.  The corruption was not limited to the Indonesians.  Some foreign institutions were deeply involved in the failures. 

Joseph Stern (Harvard University) noted that the main issue in Korea was private bankto-bank debt.  Although it was time consuming to get the banks to participate in the rollovers, it wasn’t all that difficult. 

In response, Yung Chul Park said that anyone who could get the deal that financial firms got in the rollovers would not be reluctant to participate.  He added that only when foreign lenders “saw enough money on the table did they begin rolling over.”  “Confidence played a small role” he said.

Ernest Stern didn’t agree.  He countered that he had been the co-chair of the debt renegotiations and was familiar with what led the banks to agree to the revised debt structure. “Yes the returns were attractive relative to holding defaulted debt—but the rates were below the then prevailing market rates for Korea.  Moreover, banks which had lent short term funds now found themselves with 1,2 and 3 year paper.” He added, the Korean Government’s support for the domestic banks was a significant factor, as was confidence in a quick recovery of the Korean economy and an early return to the capital markets.  The latter in fact occurred in record time after the debt had been rescheduled. 

Zia Qureshi (World Bank) commented that both countries faced a systemic crisis in their banking systems.  Korea had a systemic response—up front commitment of public resources and targets for capital adequacy rates.  The banking system continued to perform its intermediary function.  The second important difference is that to this day in Indonesia little attempt has been made to restructure the corporate debt.  Without dealing with the problem, he concluded, it is difficult to deal with the problem in the banking system. 

Charles Enoch (IMF) disagreed that a lack of systemic vision hampered Indonesia.  By the middle of 1998, he said, every bank had gone though an international audit.  Why then has the cost of fixing the banking problem gone up so much since then?  The problem has been the failure to implement measures that have been decided upon—for example, the bankruptcy law. 

David Cole commented that doing audits of banks in the midst of a downward spiral was never going to achieve meaningful results. 

Lisa Cook (Harvard University)asked the panel to what extent disintermediation had lead to barter, as it did in Russia. 

Lloyd Kenward responded that he didn’t know anything about barter, but certainly creative options were used to finance operations, such as credit from trading partners and moving corporate financial operations off-shore to locations such as Singapore.  He added that there are many companies with good balance sheets, and these have done well.  If you hadn’t been too aggressive beforehand, he said, there are good opportunities, which partly explains the growth.  Non-oil exports are booming, and the internal terms of trade have moved in favor of agricultural producers.  Construction is starting to pick up. 

Martin Feldstein (Harvard University and NBER) asked if the corporate debt to capital ratios were high in Indonesia.  He also asked if the role that Korean banks had played as an instrument of government capital allocation had made it easier to deal with the banks in Korea than in Indonesia. 

Lloyd Kenward said that the debt to capital ratio was very high, adding that profits were distributed and put offshore. 

Bambang Subianto addressed the issue of why the bank restructuring has been so slow.  He stressed that that market value is much less than the book value of the debt.  Any restructuring will thus lead to losses.  For a decision maker, taking the “right course” and taking losses will lead to suspicions of corruption.  They conclude it is better to do nothing. 

Yung Chul Park reiterated that Korea has not had a systemic response any more than Indonesia has.  The process is ongoing in Korea, which is not in its third stage of financial restructuring.  There also has been significant distermediation, with firms relying on their retained earnings.

Ernest Stern said that the corporate debt problem overhangs everything.  But he was not convinced by Subianto’s anecdote about doing nothing—which is tantamount to waiting for better times.  Unless the reality of the current value of the assets are accepted, and they are disposed of at the best price available now, they will clog the system and prevent the corporate restructuring and bank lending necessary to resumed growth.  Unutilized assets he said are not productive.  He added that corporations were less effected by exchange rate risk in Korea than in Indonesia.  In Korea the banks took a lot of the exchange rate risk.  He agreed that the differences in the success of financial restructuring are mainly of ones of implementation rather than vision. What is required in terms of principles is well understood.  More vigorous implementation was indeed necessary. He closed with the observation that the development of domestic capital markets which is taking place in Korea also is crucial in moving Indonesia away from its reliance on bank finance.

Session 4: Attempts to Recover

Martin Feldstein, Harvard University and NBER

Dennis Flannery, Lehman Brothers
Andrew Berg, US Treasury Department
Annop Singh, IMF
Anwar Nasution, Bank of Indonesia

Denis Flannery opened the session by asking why economic recovery has been slower in Indonesia than is the other crisis afflicted countries.  He offered a number of reasons:

  • The magnitude of the problems (outlined in earlier sessions) went far deeper than elsewhere.

  • The crisis coincided with a very difficult political environment.  The new government and parliament were still engaged in “on the job training.”

  • Among many of the “players” the extent of the crisis was downplayed, with very optimistic predictions being made.

  • It takes time to establish a framework for dealing with such a crisis.

  • Signing documents—e.g., IMF agreements—certifies failure.  Flannery gave the example of the Turkish debt restructuring at the end of the 1970s.  The finance minister was supposed to sign, but refused to do so.  The reason for the refusal was that 15 years previously a previous incumbent of that position had been executed for his acts as minister. 

Flannery then turned his attention to what should be done now.  The order of the day, he said, should be bold action to sell the assets for whatever price can be got.  Beyond that, the policy focus should be on preventing such a crisis from happening again.  Among the needed reforms are changes to the tax system, privatization, and financial supervision. 

Andrew Berg observed that the transformation in Indonesia is very different from the transformation in most other crisis-affected economies.  In some ways, the challenges facing Indonesia are like the challenges facing the transition economies.  But even Poland had clear models to follow.  Indonesia is struggling with basic questions where the models are not clear-cut.  As the policy makers are struggling with the economic questions, they also engaged is a nation-building exercise.

Berg noted that the country had grown without many of the institutions now deemed essential.  “But there is no going back,” he said.

As evidence that Indonesia still faces an up hill struggle, Berg pointed out that capital is still flowing out.  He asked rhetorically, “Were mistakes made?”  Notwithstanding the mistakes, he said things could have been worse.  The country did manage a reasonably peaceful democratic transition.  And there is—finally—some recovery.  As for the agenda moving forward, he pointed to the importance of institutional reform, bank restructuring, corporate reform, and developing an appropriate macroeconomic framework

Berg outlined three competing views that are held about the Indonesian situation.  The first view praises the achievement of macro stability and believes that “we should now relax and let things work themselves out.” Financial restructuring has not happened yet because companies have been able to finance themselves.  When they need credit the restructuring will follow.  The second view says that the first view is mostly true but emphasizes that the fiscal situation is precarious, with the move to greater federalism raising the risk of a fiscal crisis.  The dangers are more apparent, he said, when you look at the “quasi-fiscal balance.”  The third view is that deep structural reform is needed before sustained growth can occur.  Berg said he is in camp two (more or less). 

Berg then asked how far the IMF should push conditionality. He said that it is not tenable to support a program that you think is going to fail.  But he admitted that there are also issues of ownership and ability to implement reforms.

He ended by saying the Treasury’s conclusion was that the international community needed to stay involved, but not push to hard, encouraging ownership of the reforms.  Indonesia also needs to push ahead with IBRA asset sales.

Anoop Singh acknowledged that there is a lot of pessimism about Indonesia’s current situation.  But he feels that things are not so bad, with 3 to 4 percent growth likely for this year.  However, the outlook is “weighed down” by a public sector debt that is close to 100 percent of GDP.  There is, he said, a plausible scenario that has the public debt coming down to 65 percent of GDP.  In achieving this, the next couple of months are crucial, he said.  Reiterated this point, he added that decisions made in the next few months will determine the medium term outlook. 

What are the most important challenges?  Singh listed five:

  • In a matter of weeks [the conference was held on September 15, 2000], the President must send a budget to parliament.  This involves difficult decisions about taxes, wage policy, etc.

  • Asset recovery and restructuring are a priority.  He said there is a very simple reason for why there has been such little restructuring—the top debtors have been protected.  There is now an announced series of sales, and these sales must take place.

  • Crucial decisions are being awaited in the “home of supervision” for the banking system.

  • Perhaps most important is the question of decentralization.  In the coming weeks, said Singh, the government must decide which functions will be decentralized.

  • Finally, there is the issue of whether the IBRA will or will not meet its oversight role.  “Has debtor resistance finally been overcome?” he asked.

Anwar Nasution said that Indonesia has made impressive progress, but it remains one of the weakest in the ASEAN group.  He added that the new finance minister is qualified to move forward on many fronts, and is at present focusing on a number of key challenges. 

First, there is the need to encourage private sector investment by strengthening bankruptcy procedures, minority ownership rights, etc.  Second, there is the need to restructure a banking system that has collapsed. Nasution noted that the government and the IMF have agreed on a comprehensive bank reform program, and added that the entry of foreign banks would be the fastest way to restore confidence.  Third there needs to be fiscal consolidation.  This includes improving the tax system and disposing of assets.  He stressed that Indonesia does not have the management capacity that would allow it to wait for the prices of assets under its control to rise.  Lastly, there is a need for debt relief given the large external debt overhang.  This debt, he emphasized, requires a large resource transfer abroad.  He added, however, that the private sector external debt problem would be harder to solve. 

Nasution closed with an expression of confidence that the new government can solve these problems.

General Discussion

Drawing a contrast with Russia, Simon Johnson (MIT and NBER) said the main question for Russia is—can Russia grow?  Indonesia grew before.  What is needed now to restore growth is stability.  Again drawing a contrast with Russia, Johnson expressed the view that entrepreneurs in Indonesia have quite secure property rights.  The problem is the relationship between the entrepreneurs and would-be investors.  He also suggested that an imagination approach be taken to private sector debt workouts.

Referring to Anoop Singh’s list of important decisions, Yung Chul Park (Korea University) agreed that they are important.  But said that many of the decisions had been taken two or three years ago, and added that it takes time for Indonesia to develop institutions.  “Nothing,” he said, “is going to happen in the next four months.”

David Cole noted that a lot of effort has gone into institutional development.  The system worked reasonably well before and then it broke down.  Cole said that now we are saying that Indonesia needs all new institutions.  Instead, he said we should be asking what worked before and how can it be made to work better now.

Drawing on experience of Thailand, Steve Radelet (Harvard University, currently on leave with the US Treasury) said that Thai firms only sat down to discuss restructuring when capacity constraints were met and they needed new investment. 

John Bresnan (Columbia University) pointed out that instability leads to insecurity, adding that the army is not in control of its people in many parts of the country.  Consequently, the opportunities for institution building in the next months are limited.

Denis Flannery (Lehman Brothers) said the new economic team knows what they have to do.  They have to sell assets and finalize some debt restructurings.  What is needed is bold political leadership—leadership that has not been demonstrated.

Anoop Singh (IMF) responded to criticisms of his stress on the next four months by saying that the four-month model is not being foisted on Indonesia.  He said that there simply are some decisions that they must take.  They have announced that they will do things.  “How they decide will be very crucial,” he said.

The final comment to the gathering was from Anwar Nasution.  He warned of a lack of knowledge about how to assess risk and manage balance sheets.  “This,” he said, “is the result of the period of financial repression.”