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.