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Asian Financial crises

Chapter 8 Causes and Implications of the Asian Crisis: An Indonesian View

International Monetary Fund
Published Date:
January 2001
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As it has been said by many, the Asian crisis stands out as one of the major crises of the century, especially for those economies which are experiencing the turmoil. The impact of the crisis has been so devastating that even pessimists acknowledge that it has been worse than their expectations. Indonesia, together with Thailand and South Korea, has been suffering more than others have. And it is certainly indisputable to argue that, among the three, the Indonesian case is the worst. In terms of the decline in economic growth, depreciation of the currency, social dislocation, and other problems, Indonesia has undoubtedly suffered the most.

I will discuss the causes and implications of the crisis, the role of the financial sector, and domestic policies as they have been unfolding in Indonesia with a view to the Asian context. By offering an assessment of how the crisis has been unfolding, the policy responses by the monetary authority, and reactions from the market players, one could get a clearer picture of the crisis facing the Indonesian economy and the contagious process impacting the Asian economies.


There have been so many conferences and writings on the Asian crisis, discussing the causes, the implications, as well as lessons to be learned from it, and one could be sure that studies about the crisis and its implications will continue in the years to come. This is due to the fact that despite the attention that it received, the crisis has been going on for a period longer than people thought. And the effects have been more devastating than most of us expected. There have even been signs recently that it could be developing into a global crisis.

Current views on causes of the crisis could be separated into two catagories. First, those who view the origin of the crisis as domestically grown, arising from practices of crony capitalism and weak financial structures plus inept macro policies. Second, those who view the contagion process triggered by a shift in the market sentiment, in other words external factors, as the origin of the crisis. It is my view that the Indonesian crisis came from a combination of contagion from outside the national economy on the one hand and weak domestic economic and financial structures on the other. The contagion factor of the crisis was emanating from a sudden change in market sentiment in the region that led to a shock in the currency markets of the region. This led to paniced selling of local currencies for dollars. The shift in market sentiment was demonstrated by the rapid downgrading process of the region’s sovereign credit ratings and, in the media, the disappearance of the term “Asian miracle” to be replaced by “crisis,” or “meltdown.” But, the most telling was the Institute of International Finance’s publication on capital flows for Thailand, Malaysia, Indonesia, the Philippines, and South Korea, which showed a dramatic shift from inflows of $93 billion in 1996 to outflows of $12 billion in 1997, or a change of capital flows of $105 billion in a single year. For Indonesia, the reversed capital flows of last year were estimated to reach $22 billion, from inflows of $10 billion to outflows of $12 billion

Confronted with the contagion effects, the Indonesian economy, which had been suffering from inefficiency in the real sector (a high cost economy suffering from crony capitalism) and a weak financial system—banking in particular—could not cope with the shock. The domino effect of the weakening rupiah adversely affected the financial sectors, and on into the real sectors of the national economy. Thus, a combination of severe external shocks, triggered by changes in market sentiments, and financial real-sector structural weaknesses had caused a contagions process that ultimately severely damaged the whole economy.

The contagion process has been working not just across geographical or national borders. Within a country, it trespasses all aspects of lives, from economic to social and political. As I observed, in Indonesia the spread from economic crisis to a social and political crisis was also through a contagion process, which was facilitated by inherent weaknesses in our social and political systems.

A more careful study on the causes of the collapse of the Indonesian economy over the past year has to be conducted. However, it seems clear that a combination of political and economic forces, both external as well as domestic, had been at work such that when a contagion effect from the Thai baht devaluation hit the rupiah, the Indonesian economy was already collapsing.

But, how did the crisis develop? Basically, the Indonesian crisis originated from an ordinary currency problem, when rupiah suffered from sudden pressure in July of last year, after the floating of Thai baht in early July 1997. However, after a process of policy responses by the government and reaction from the market, the problems spread rapidly and deeply to effect all sectors of the national economy, before finally impacting politics.

The process of how the crisis developed in Indonesia could be described as followed:

  • It started with market pressure on the rupiah as part of the contagion effects from imbalances in the currency markets in the region. Facing such pressure in the currency market, the government, based on its exchange rate management policy of a managed float with creeping depreciation, which relied on the mechanism of intervention bands which had been adjusted continuously since 1994, took the decision to further widen the bands from eight percent to twelve percent on July 11, 1997—the day the Philippine peso was floated.
  • The market reaction to Bank Indonesia’s move was in contrast to its past pattern. Previously, every time the BI intervention bands were widened (five times from 1994 to 1997) an appreciation of the rupiah usually followed. However, this time the rupiah rapidly depreciated instead. When the spot rate crossed the BI-selling rate, some intervention in the currency market was exercised. This intervention began with forward sales of dollars in the beginning, and later progressed to spot sales. The pressure on the rupiah was not abating, however, despite market intervention by the central bank.
  • Bank Indonesia floated the rupiah on August 14, 1997. Intervention in both the forward and spot markets was continued. To support the currency intervention, monetary tightening, through monetary and fiscal means, was conducted.
  • After Bank Indonesia intervened in the market several times and exercised monetary tightening, the problems started to spread to include the banking sector. The Indonesian banking industry started to experience distress. And, as the problems continued, confidence in the banking sector started to decline. The banking sector experienced the familiar process of flight to quality and flight to safety. A crisis of confidence started to appear, through the weakening of the rupiah, tiering of the interbank money market, and a loss of confidence from bank depositors and creditors.
  • After some time, the real sector started to feel the impact since banks reduced their lending and lending rates rose dramatically. The banking sector experienced a crisis, especially after the closing of the sixteen insolvent banks. Thus, starting from currency shocks and the rupiah crisis, through to banking distress and a banking crisis, the final result was a total economic crisis.1
  • The impact of the economic crisis on politics and society almost became self-fulfilling. When economic recession became a reality, social unrest broke out everywhere and public confidence in the government and the national leadership was gone.


The initial policy response to the currency problem was prompt. It started with an immediate step to widen the central bank intervention bands in the foreign exchange market, soon after the Thai baht was floated early in July 1997. However, a completely different reaction came from the market. On previous occasions, every time Bank Indonesia widened the intervention bands—five times since 1994—the rupiah was appreciated. In fact, previously the dollar spot rates followed closely the buying rates of Bank Indonesia. But, this time, the rupiah depreciated after the bands were widened. The spot rate of the dollar not only broke through the mid-rate, but it also broke through the central bank’s selling rate. The latter prompted Bank Indonesia to intervene in the market. It could now be said that what happened in July 1997 was definitely different from previous periods of pressure in the currency market. It was, to be sure, a contagion effect in progress.2 This is “the wake up call” argument for the Asian crisis. Investors basically believed that Southeast Asian economies had similar weak conditions such as crony capitalism practices and weak financial systems. In this condition, a shift in market sentiment leads investors to follow their “herd instinct” that tells them to move their capital out of Asia.

Faced with persistent pressure on the rupiah, the government intervened in the foreign exchange market, first by selling dollar forward, and later, in the spot market. When these efforts could not strengthen the rupiah, Bank Indonesia discarded the managed floating exchange system, and floated the rupiah freely in mid-August 1997. These were done with the support of monetary tightening through drastic increases in interest rates, administrative intervention, as well as fiscal tightening. But, partly due to the monetary and fiscal tightening, the weak banking sector started to suffer from distress. In fact, a sizeable bank (Bank Dannamon) had suffered from a run in late August 1997.

Realizing the fact that the problem had spread to the banking sector, in early September 1997 the government launched a broad economic policy initiative, which encompassed not just monetary and fiscal measures, but also deregulation steps in the real sector. This was a precursor of an IMF-supported program, which came later, at the end of October 1997.

The IMF-supported program was introduced through a letter of intent with a Memorandum on Economic and Financial Policies (MEFP), submitted to the fund on October 31, 1997. The program was comprised of a package of policies for economic reform in the real sector and financial restructuring to be supported with prudent monetary and fiscal policy. The monetary and fiscal measures were comprised of standard programs of macroeconomics management to cope with exchange rates and other monetary variable issues together with fiscal ramifications.

The core of the program was comprised of a comprehensive policy package to deal with insolvent and weak banks and the financial infrastructure, including the strengthening of banking supervision, and to overcome structural rigidities in the real sector of the economy. Thus, a framework was put in place for a comprehensive policy to restore confidence and arrest the decline of the rupiah. In essence, the program was built around three areas:

  • A strong macroeconomics framework designed to achieve an orderly adjustment in the external current account, incorporating substantial fiscal adjustments as well as a tight monetary stance,
  • A comprehensive strategy to restructure the financial sector, including early closing of insolvent institutions, and
  • A broad range of structural measures which also improve governance.

Initially, the implementation of the program received a positive response from the market, the external market in particular. The closing of sixteen insolvent banks and joint intervention in the currency market by Bank Indonesia, together with the Monetary Authority of Singapore and the Bank of Japan, were welcomed by the (external) market and resulted in the strengthening of the rupiah, temporarily stabilized it at a stronger rate—from 3,900 rupiah to 3,200 rupiah to the dollar.

However, the domestic reaction to the closing of banks was the reverse of what was expected. It was ironic that a step, which was designed to return confidence to the banking sector, instead resulted in the collapse of confidence, which plunged the banking sector into chaos. The banking sector has suffered from a “flight to safety and to quality” since then. Many banks lost their deposit base, the inter bank money market suffered from compartmentalisation, and since January 1998, letters of credit issued by Indonesian banks were not accepted abroad. The problems of confidence in the national economy basically involved three areas: the rupiah exchange rate which was weakening dramatically against the dollar, the banking sector which was losing its deposit base as well as creditors, and the business sector that was unable to repay foreign debts.

After some flip-flop implementation of the IMF-supported program with a record four letters of intent in seven months, coupled with social unrest spearheaded by continuous students’ demonstrations, the confidence problem shifted from not just an economic problem but to a problem of national leadership as well. When Suharto was still in power the overriding question was his sincerity in implementing the difficult reform program. Actually, the market—the foreign market—lauded the closing of sixteen insolvent banks in particular. But domestically the closing of banks was badly received. It even caused further loss of confidence in the banking system. However, when some political intervention by the government was suspected on the execution of bank closures, the foreign market started to react negatively also. This had basically transformed the banking sector from a state of distress into a crisis when market confidence was almost completely lost.

The negative reaction to the implementation of the reform program was more pronounced when a reversal was announced to postpone big government projects. At about the same time there was a reappearance of monopoly practices and some other inconsistencies in the implementation of the program for restructuring the real sector. This was how market confidence evaporated in the government’s commitment to the program for economic restructuring. As a result, the rupiah’s downward slide was not just difficult to stop, but the economic crisis was rapidly shifting into a total crisis in a downward spiral. President Suharto had to pay dearly for not addressing the problem head-on by resigning in humiliation on May 21, 1998.

In five months after his unexpected elevation as the new president, Dr. Habibie has been surprising many people as a national leader who has been trying very hard to do and say things that are politically correct. He has been making positive steps in human rights and scoring some points in strengthening the rupiah. But, has he been successful in eliminating the loss of confidence in the national leadership to be able to lead the government and the nation to implement the national program for restructuring economic and political lives in Indonesia? At this point the answer is no.

Despite the good publicity that President Habibie has been receiving so far, the market has not been impressed with his leadership. In fact, statistics on maroeconomic indicators have shown a gloomier picture in terms of GDP growth prospects, the inflation rate, the budget deficit, and the situation with regard to food and other basic commodities. The rupiah has been strengthening somewhat, possibly due to some encouraging news recently about the $8 billion loan for fast disbursement from the CGI. But, the bad news from Japan and its implication for Asia and the still unclear government position about some social issues seem to have caused lukewarm attitude of the market so far. Investors and creditors keep saying that they still want to wait for the return of social and political stability first before they are willing to invest in or lend to Indonesia. They trust the long-term potential but are waiting for some time before resuming their activities in Indonesia. In other words, despite the positive public reception to some statements or steps that President Habibie has recently made, questions are still being raised, if not on whether he is sincere, on whether he is able to deliver.


It has been stated above that in the Indonesian case, the crisis which came out in the beginning as a currency problem due to an external shock, through a contagious effects triggered by a shift in the market sentiment, became a fully blown crisis involving economic, social and political crisis. Weak economic structure and unsound financial system facilitated the economic contagion.

Indeed, it has been conjectured that banking soundness is vital for a sustainable macroeconomic management of a national economy. Despite the continuous competition from other financial intermediaries as a result of the globalisation process, the banking sector still plays a dominant role in a national economy, particularly in developing countries. The condition of the banking sector generally reflects the status of the financial sector as a whole. Thus, there is an overriding concern over bank soundness.

According to the IMF Executive Board, efforts to strengthen the banking system should be guided by the following principles:3

  • The soundness of a bank is first and foremost the responsibility of its owners and managers; yet the soundness of a banking system is a public policy concern;
  • Bank soundness is crucially linked to sound macroeconomic policies;
  • A framework for sound banking must include structures to support internal governance and market discipline, as well as official regulation and supervision; and
  • International Cupertino and coordination can play an important role, not only in strengthening the global financial system, but also in improving the soundness of the national banking system.

Let me summarize how bank restructuring was conducted in Indonesia with a view to the principles mentioned before. Prior to the current banking crisis, the most recent experience of dealing with problematic banks was the closure of Bank Summa, a sizable bank, at the end of 1992. A significant number of banks, including a major portion of the seven state banks and some provincial governments’ development banks were faced with serious problems of nonperforming loans, partly as an implication of a step in the monetary policy to deal with the overheating of the economy in 1991–1992. The IMF classified the condition of the Indonesian banks in its study as a system experiencing significant problems.4 The closing of Bank Summa was a distressing experience for Bank Indonesia, since it took a long time to resolve. However, over the course of time, conditions improved as shown by the national average of nonperforming loans, which declined from twenty-five percent of total lending in 1993 to twelve percent in 1995.5

The banking crisis was preceded by a short period of distress when, due to a process of erosion of confidence, banks lost their deposits’ base. In addition, the interbank money market functioned poorly, suffering from compartmentalization. Weak banks had to rely on Bank Indonesia’s facility for liquidity to keep afloat. Confidence was completely lost when “flight to quality” was rampant and a substantial number of banks were confronted with bank runs within a short period of time. Strangely, in the Indonesian experience, this phenomenon happened following the closure of the sixteen banks in early November 1997, a step which was originally designed to boost confidence in the banking system. Individually, a bank confronted with problems of mismatched liquidity could easily become insolvent during a period of crisis. For the banking sector, the problem changed from a distress to a crisis.

When currency crisis spread to inflict the national economy, the government’s efforts to address the banking problems were combined with other policies and treated as a part of the adjustment policies for stability and sustaining growth. But, this treatment was more explicit in the IMF supported programs, from the first letter of intent in October 1997 to the most recent one in September 1998.

The Indonesian government asked for a three-year standby loan from the IMF, which was processed through an emergency procedure.6 The loan was SDR 7.3 billion, and together with those provided by the World Bank and the Asian Development Bank (ADB), the total amount was $18 billion. This amount, plus $5 billion of Indonesia’s own reserves set aside for balance of payments support, made a total of $23 billion available to be drawn. And together with bilateral participation in a second line of defence, the total amount of the package amounted to $43 billion. This is what popularly known as the Indonesian bail out.7

Basically, the IMF-supported program was comprised of a comprehensive policy package to deal with insolvent banks, and to overcome structural rigidities in the economy, supported by prudent fiscal and monetary policy. The financial restructuring program, which had been put together with technical assistance from the IMF, the World Bank, and the ADB to restore public confidence in the financial system, was comprised of five parts, namely:

  • The closure of sixteen insolvent banks, which was executed on November 1, 1997.
  • The establishment of proper procedures and policies to deal promptly with weak but viable financial institutions, so that they can be placed quickly on the road to recovery; some banks were to be put under intensive supervision by BI.
  • The resolution of specific problems of state and regional development banks.
  • The strengthening of the institutional, legal and regulatory frameworks for banking operations to ensure the emergence of a sound and efficient financial system; this program includes the modification of such laws as the central bank law, the law on bank liquidation, and the bankruptcy law.
  • The establishment of Indonesia Bank Restructuring Agency (IBRA), after the second letter of intent.

The program of banking restructuring was part and parcel of a comprehensive program that comprises both the real and financial sectors, supported by prudent fiscal and monetary policy.

If we look at what was put into the program, one could argue that the right steps were taken to address the Indonesian crisis. But, why is Indonesia’s IMF-supported program showing negative results thus far? In comparison with the implementation of other IMF-supported programs, the Indonesian case is definitely the worst, particularly when one compares the rate of currency depreciation, growth prospects, inflation, and the development of other variables in the respective countries.


Based from my assessment on what have been unfolding in Indonesia, the followings are some lessons to be learned for future efforts to address banking sector problems:

  • Some lessons from financial liberalization policies in Indonesia, which were primarily adopted in the late 1980s and 1990s, are in order. The Indonesian experience underlines the argument that banking liberalization has to be done in coordination with the improvement of the financial infrastructure, including strict prudential measures and supervision, adequate disclosure, governance, legal protection, and market discipline. Proper sequencing is very good, but different original condition may require different sequence. Furthermore, it is impossible to move backward or to retract once a path of liberalization is adopted.
  • Lessons from the past crises are still valid here, namely that the sooner the better and the problems are usually worse than expected.8 In the Indonesian experience, an IMF study for Bank Indonesia in 1996 showed the number of problem banks and cost for their restructuring, both were much smaller than the estimated magnitudes in the IMF supported program. Basically, the sooner the problems are identified or recognized and the sooner they are properly addressed, the smaller the cost involved and thus, the better the chances for success.
  • On banking soundness as a requisite for sustainable monetary policy, I would argue that the Indonesian experience supports the contention. It is even plausible to suggest that the linchpin of the crisis is the weak banking system, which has constrained the monetary authority in conducting monetary policy and banking supervision as well as facilitating a payment system. I think the inclusion of banking soundness, as an explicit objective of monetary policy, as argued by Guitián, should be seriously considered.9 However, I cannot help but note that, even though there has been an increasing awareness of the close link between banking soundness and macroeconomic policy, partly due to the socialization campaign by the IMF and others, it has not been adequate to prepare monetary authorities and market players in developing countries to cope with the crisis. And this lack of preparation has resulted in devastating impacts, especially in Thailand, South Korea and Indonesia. The sooner must have been the better.
  • In an effort to create a sound banking system by implementing a program that combine bank restructuring and monetary management, we have to be very cautious about the fact that we are working with different variables in terms of their time frame. Monetary policy deals with variables, which have short time lag, even though it has long term implications. To adopt a tight or lose monetary policy is a short-run issue. Furthermore, it deals with macroeconomic variables. Bank restructuring is, however, a long-term problem. It deals with problems of efficiency, management, supervision, regulation, law enforcement, banking ethics, etc., which are long terms and microeconomic issues. I do not want to imply that because they are long-term problems a country has more time to address them. The point I would like to raise is that we have to be extra careful in designing and implementing a program that combines monetary policy and banking reform. They are very closely related, and yet they are problems of different nature.
  • The Indonesian experience also teaches us that, when public expectation is fragile, the closure of insolvent banks, a must for creating a sound banking system, could have an adverse result. A step, which was originally intended to regain public confidence, resulted in a further loss of it. Liquidation of banks should be done when the economy is not in distress, when public expectation is not fragile. This is, of course, easier said than done. However, it remains true: the sooner the better, and the later the costlier.

Experts distinguish between banking distress, when a number of banks suffer an insolvency problem, even though not a liquidity problem, and banking crisis. Banking crisis is defined as a situation in which a significant group of banks have liabilities exceeding the market value of their assets, leading to runs and other portfolio shifts, collapse of some banks, and government intervention. Read V. Sundararajan and Tomas J.T. Balino, (eds,) Banking Crisis: Cases and Issues, Washington DC: IMF, 1991, p. 3.


The impact of the Mexican crisis in January 1996 and the strengthening of the yen in April 1996 occasioned the previous external shocks. In both instances, the rupiah was weakened substantially, but it recovered within days, after Bank Indonesia’s intervention.


Carl-Johan Lindgren et al., Bank Soundness and Macro-economic Policy, Washington, DC: IMF, 1996, p. 5


Carl-Johan Lindgren et al., ibid., p.26.


On the main issues confronting Indonesia in coping with banking system management and banking reform prior to the present crisis, see David C. Cole and Betty Slade, Building a Modern Financial System: The Indonesian Experience, New York: Cambridge University Press, 1996. I also wrote a paper “The Banking Sector in Emerging Markets: The Case of Indonesia” published in Charles Enoch and John H. Green (eds.) Banking Soundness and Monetary Policy, Washington, DC: IMF, 1997, pp. 335–352.


In the preparatory discussions, my preference was for a ‘precautionary arrangement’ instead of a full-fledged stand-by arrangement, partly because of my concern about the possible problems arising from the conditionalities of a stand-by loan.


Some questions have been arising on the exact amount available to be drawn, what was actually the $5 billion of Indonesia’s own reserve, what was the second line of defence, etc. These have to be clarified for the records.


See Andrew Sheng, The Crisis of Money in the 21” Century, City University of Hongkong, guest lecture, April 21, 1998.


See Manuel Guitián, “Banking Soundness: The Other Dimension of Monetary Policy,” in Banking Soundness and Monetary Policy, Charles Enoch and John H. Green (eds.), pp. 41–62. See also Richard N. Cooper in his comment on Steven Redelet and Jeffrey D. Sachs, ‘The East Asian Financial Crisis: Diagnosis, Remedies, Prospects,” in Brookings Papers on Economic Activity, Vol. 1, 1998.

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