Asian Financial Crisis in Indonesia

The Indonesian Crisis Begins

Although the Asian region showed worrying signs, foreign investors initially kept confidence in the Indonesian technocrats' ability to weather the financial storm (as they had done before in the 1970s and 1980s). But this time, however, Indonesia would not get off scot-free. It became the hardest-hit country because the crisis not only had economic but also significant and far-reaching political and social implications.

When pressures on the Indonesian rupiah became too strong, the currency was set to float freely starting from August 1997. Soon it began depreciating significantly. By 1 January 1998, the rupiah's nominal value was only 30 percent of what it had been in June 1997. In the years prior to 1997 many private Indonesian companies had obtained unhedged, short-term offshore loans in US dollars, and this enormous private-sector debt turned out to be a time bomb waiting to explode.

Continued rupiah depreciation only worsened the situation drastically. Indonesian companies rushed to buy dollars, thus putting more downward pressure on the rupiah and exacerbating the companies' debt situation. It was certain that Indonesian companies (including banks; some of which were known to be very weak) would suffer huge losses. New foreign exchange supplies were scarce as new loans for Indonesian companies were not granted by foreign creditors. As the government of Indonesia was unable to cope with this crisis it decided to seek financial assistance from the International Monetary Fund (IMF) in October 1997.

The IMF Arrives and Chaos Continues

The IMF arrived in Indonesia with a bailout package totaling USD $43 billion to restore market confidence in the Indonesian rupiah. In return it demanded some fundamental financial reform measures: the closure of 16 privately-owned banks, the winding down of food and energy subsidies, and it advised the Indonesian Central Bank (Bank Indonesia) to raise interest rates. But this reform package turned out to be a failure. The closure of the 16 banks (some controlled by Suharto's cronies) triggered a run on other banks. Billions of rupiah were withdrawn from saving accounts, restricting the banks' ability to lend and forcing the Central Bank to provide large credits to the remaining banks to avert a complete banking crisis.

Moreover, the IMF did not try to curb Suharto's system of patronage that was damaging the country's economy and undermining the IMF accord. This patronage system was Suharto's tool to maintain power; in exchange for political and financial support, Suharto gave powerful positions to his family, friends and enemies (thus becoming cronies). Other developments that were negatively impacting on Indonesia towards the end of 1997 were a serious El-Nino drought (bringing severe droughts that caused forest fires and poor harvests) and rising speculation about Suharto's deteriorating health (which caused political uncertainties). Gradually, Indonesia was heading towards a political crisis.

A second agreement with the IMF was needed as the economy was continuing its downward spiral. In January 1998 the rupiah lost half of its value within the time-span of five days only, causing Indonesians to hoard food. This second IMF agreement contained a detailed 50-point reform program, including provisions for a social safety net, a gradual phasing out of certain public subsidies and the tackling of Suharto's patronage system by ending monopolies of a number of his cronies.

However, reluctance of Suharto to implement this structural reform program faithfully, meant that the situation did not improve. Critics of the IMF, however, point out that the institution pushed for too much reform within too little time, thereby worsening the Indonesian economy. The IMF indeed made errors in its initial approach to the Indonesian crisis but it did come to realize that the key in overcoming this crisis was to restart private capital flows to Indonesia. In order for this to happen the patronage system had to be broken down.

Indonesian GDP and Inflation 1996-1998:

	1996	1997	1998
GDP growth  (annual percent change)	8.0	4.7	-13.6
Inflation growth  (annual percent change)	6.5	11.6	65.0

^{Source: Hill, H. (2000). The Indonesian Economy, p. 264}

A third agreement with the IMF was signed in April 1998. The Indonesian economy and social indicators were still showing worrying signs. But this time, however, the IMF was more flexible in its demands than on previous occasions. For instance, large food subsidies for low-income households were granted and the budget deficit was allowed to widen. But the IMF also called for the privatization of state-owned companies, faster action on bank restructuring, a new bankruptcy law as well as a new court to handle bankruptcy cases. It also insisted on the closer monitoring of its implementation as recent experiences had shown that the Indonesian government was not fully committed to the reform agenda.

The Crisis Hits its Climax

In the meantime, major social forces were at work as well. Demonstrations and criticism directed towards the government of Suharto intensified severely after he was re-elected and had formed a new cabinet in March 1998. This provocative new cabinet contained a number of members from his crony-group and therefore did little to restore confidence in the Indonesian market. After the government decided to reduce the subsidies on fuel in early May, large-scale riots broke out in Medan, Jakarta and Solo. Although the IMF had given Suharto time until October to reduce these subsidies gradually, he decided to do it all at once, probably underestimating its impact or overestimating his own position.

The tense atmosphere came to a climax when four Indonesian students were killed during a protest at a local university in Jakarta. It is suspected that an army unit of the special forces was behind these shootings ('Trisakti shootings'). The next couple of days Jakarta was plagued by the worst riots ever. As had happened before, the ethnic Chinese - disliked for their assumed wealth - were often target during these violent riots. Chinese stores and houses were burned to the ground and Chinese women brutally raped. When the riots calmed down, more than one thousand people had lost their lives and thousands of buildings were destroyed. On 14 May 1998 President Suharto stepped down from the presidency when all politicians refused to join a new reorganized cabinet. The financial crisis had fully grown into a social and political one.

A New Political System and the Start of Recovery

Bacharuddin Jusuf Habibie, vice-president in Suharto's last cabinet and thus - by law - replacing Suharto as Indonesia's next president, turned to the economic technocrats to deal with the ongoing financial crisis. This resulted in a fourth agreement with the IMF. It was signed in June 1998 and allowed the budget deficit to widen further while new funds were pumped into the economy.

Within the time-span of a couple of months there were some signs of recovery. The rupiah began to strengthen from mid-June 1998 (when it had fallen to 16,000 rupiah per dollar) to 8,000 rupiah per dollar in October 1998, inflation eased drastically, the Jakarta stock exchange started to rise and non-oil exports started to revive towards the end of the year. The banking sector (center of the crisis) remained fragile as the number of non-performing loans were high and banks were very hesitant to loan money. Moreover, the banking sector had caused a sharp increase in government debt as this debt was primarily due to the issuance of bank restructuring bonds. But, albeit fragile, Indonesia's economy improved gradually through 1999, partly due to an improving international environment which caused a rise in export revenues.

Lessons Learned from the Asian Financial Crisis

It is interesting to question what chances are of such a crisis occurring again in Indonesia in the foreseeable future. Most likely chances are small. First of all it needs to be stressed that the Asian Financial Crisis hit Indonesia hardest of all involved countries because it was not just an economic crisis. It started out as an economic crisis but became severely aggravated because it was accompanied by a deep political and social crisis in which the government was not willing to implement much needed economic reforms but instead was trying to cling on to their hold of power. As an orderly and conducive political climate is of vital importance for investor confidence, the uncertainties and tensions in Indonesian politics made many investors turn their back to the country. Also after Suharto's fall, political uncertainties put off many investors (foreign and domestic) to (re)enter the Indonesian market.

Today, however, Indonesia is well on its way to become a full democracy, albeit its a process that is accompanied by growing pains. Decades of authoritarian rule have depoliticized the people and political institutions to a considerable extent. It will take time before the country can leave behind the rank of 'flawed democracy' as measured by Economist Intelligence Unit for its Democracy Index. But fair and free elections imply that there has been more popular support for the governments during the Reformation period than ever before. The decision to have the president directly elected by the people is an important one, psychologically. Nonetheless, it should be underlined that the Indonesian political climate is more volatile than long-established democracies due to many dissenting forces looking to establish their position in the young democracy. For a detailed account on this topic visit our Reformation section.

Another important factor that seriously aggravated the financial crisis in Indonesia was the terrible state of the Indonesian financial sector. This was caused by a culture of patronage and corruption which lacked a decent supervision model. Even the Central Bank had no idea about the flows of money (and resulting huge short-term private debt) which entered Indonesia and caused a 'bubble economy'. The culture of patronage and corruption (and lack of legal certainty) seriously hampered the functioning of an efficient economy and was a time bomb waiting to explode.

Since the end of the crisis, however, Indonesian governments have made prudent financial measures to make sure a similar crisis cannot happen. Supervision on liquidity of the banking sector is strict and transparent, 'hot money' is more carefully handled (for example by halting short-term debts), and the government's debt-to-GDP is lower (around 25 percent and showing a decreasing trend) than most economic advanced countries. When the 2008 crisis hit, Indonesia saw a large outflow of money again but was able to guarantee a stable economy due to sound economic fundamentals. Even during this 2008-2009 crisis Indonesia showed robust growth with 4.6 percent GDP growth, mainly due to domestic consumption.

Graft scandals, however, still fill the pages of Indonesian newspapers on a frequent basis. Corruption and the clustering of capital within the small elite are still serious problems in the country and hamper the economy from being more efficient and righteous. In particular political corruption remains problematic and quite often politicians have major business interests (such interests influence their political vision).

Read more about Corruption in Indonesia.