FINANCIAL CRISIS IN INDONESIA: Problem, Solutions, and Lessons

1. FINANCIAL CRISIS IN INDONESIA: Problem, Solutions, and Lessons FISKARA INDAWAN Econ 522, Spring 2007 May 1, 2007 University of Illinois, Urbana-Champaign

2. Outline • The root of financial crisis in Indonesia • Why Indonesia had the worst crisis? • What was the policy response for the crisis? • What lessons can be drawn from the crisis? • Conclusion

3. The root of financial crisis in Indonesia • In the pre-crisis period, Indonesia received huge capital inflows external and internal factors. • External factors: high sustainable economic growth while most part of the world and industrial countries showed stagnant growth. • Internal factors: financial liberalization in 1980s-1990s cheap fund from abroad. • However, there were no official figures about foreign borrowing by private sectors source of shock for fixed exchange rate regime.

4. Why Indonesia had the worst crisis? • Financial crisis in Indonesia a multi-faceted crisis (so many events correlated each other to make situation worsened). • At first the crisis was contagion effect from Thailand. • GOI responded by floating Rupiah, delaying big infrastructure projects, and closing insolvent banks.

5. Why Indonesia had the worst crisis? • However, the policy could not calm the market Rupiah depreciate by 36% & JSX plunged by 40% private sectors could not serve their foreign liabilities. • GOI asked IMF assistance. • Situation became worsened: renew attack on Korea, GOI commitment to IMF program, and mature hugh short term debt. • As a result, sharp depreciation of Rupiah until the level of Rp17,000/USD in mid-Jan 1998 from previously Rp2,100-2,500 since 1992.

6. What was the policy response for the crisis? • GOI had no choice but asking IMF assistance to restore the confidence, and hence, the economy. • Policy response to the crisis was mostly come from letter of intent (LOI) highlighted by IMF. • Principal notion of IMF program: “the enormous depreciation of the rupiah did not seem to stem from macroeconomic imbalances, which remained quite modest. Instead, the large depreciation reflected a severe loss of confidence in the currency, the financial sector, and the overall economy” (LOI 01/15/98).

7. What was the policy response for the crisis? • IMF divided the program into 5 main parts, fiscal policy, monetary policy, financial sector restructuring, corporate restructuring, and structural reforms. • Fiscal policy: - increasing the revenue and reducing the spending. - target: budget surplus 1% of GDP. • Monetary policy: tight money policy situation worsened.

8. What was the policy response for the crisis? • Financial sector restructuring: - Liquidate more insolvent banks. - Merger and acquisition among banks. - Strict rules on prudential banking (CAR, risk-based supervision). • Corporate restructuring: set up Indonesian Debt Restructuring Agency (INDRA) to restructure corporate debt and established new bancruptcy law. • Structural reforms: privatisation, deregulation, and trade and investment reforms.

9. What lessons can be drawn from the crisis? • Good governance must be the main prerequisite for financial market liberalization. • A country must have a huge foreign reserves and credible government to support fixed exchange rate policy. • Government credibility is the key success to restore the economy when a country has been hit by financial or economic crisis. • In the global market, a country must have a strong and sound domestic financial market.

10. Conclusion • Financial crisis in Indonesia: multidimensional crisis. • Main problem of financial crisis in Indonesia: excessive foreign borrowing by the government and private sectors. • The policy response came in the form of letter of intent signed between Indonesia and IMF. • A country that adopted fixed exchange rate must have a huge foreign reserves and credible government policy.