Crisis Development

had well under half of their debt hedged. Borrowing US dol-lars was part of life in Indonesia – "it was like going to McDonald's" [22]. Everyone assumed that the money would always be available, and took advantage of this situation.

After 30 years of steady economic growth, the corporate sector didn't seem to fear economic downturn.

Some of the loans were used to finance speculative investments in such areas as equity purchases and real estate. Property loans grew at an annual rate of more than 60% during 1992–1995 (compared to 20–25% percent rate of growth for total credit) and in April 1997 accounted for 19.6% of outstanding bank credits. To restrain the growing

exposure of the banking system to this sector BI restricted in July 1997 commercial banks from extending new loans for land purchases and property development (except for low-cost housing). Total credit growth also continued, in spite of consecutive statutory reserve requirements increases (from 2% to 3% in January 1996 and an announcement of a rise to 5% in April 1997) and other attempts by BI to contain it.

The growing uncertainty about the future development on the exchange rate market was reflected by an increase in the volume of forward and swap rupiah transactions. Their average daily turnover rose from around 4.5 bln USD in early 1997 to about 6.2 bln USD in June/ July 1997. The increase in trading illustrates increased hedging activities among externally indebted domestic companies. However, nobody expected that a sharp downturn and such a severe crisis would erupt.

widened the trading bands from 8% to 12% (and inter-vened when the rate moved outside the band). On July 14, Malaysia gave up its currency peg. It took one more month and a 15% depreciation until Bank Indonesia floated the rupiah and doubled short-term interest rates to over 25%

to support its value [23]. On August 29, BI introduced

restrictions (up to 5 mln USD per customer) on nonresi-dents' trading in forward currency contract (i.e. supposed speculation). Despite this, capital outflows continued and by October 8, the rupiah/dollar exchange rate had already depreciated cumulatively by 46%. By that day, matters went so badly with domestic financial and corporate sector

[23] To what extent the rupiah collapse has been caused by speculators or by domestic investors suddenly starting to hedge against exchange risk is a subject of great debate. Indonesian authorities (Minister of Justice in August) claimed that the speculators were guilty and their activities could be interpreted as subversive criminal actions (there is a death penalty for subversion), while hedge-fund managers and other participants suggest that this was not the case. Major funds were fully invested in the rupiah and they even supposedly bet on the rupiah rebound at some moment. But it was the case that many unhedged domestic companies decided to insure in forward market against the rupiah decline. Of course, speculators joined the mar-ket when depreciation seemed to be inevitable.

Figure 5-16. Indonesia: rupiah exchange rate (IDR/USD)

0 2000 4000 6000 8000 10000 12000 14000 16000 18000

97-03-17 97-04-17 97-05-17 97-06-17 97-07-17 97-08-17 97-09-17 97-10-17 97-11-17 97-12-17 98-01-17 98-02-17 98-03-17 98-04-17 98-05-17 98-06-17 98-07-17 98-08-17 98-09-17 98-10-17 98-11-17 98-12-17 99-01-17 99-02-17 99-03-17

Source: Bloomberg

Figure 5-17. Indonesia: Money market rate

0 10 20 30 40 50 60 70 80 90

1996M1 1996M3 1996M5 1996M7 1996M9 1996M11 1997M1 1997M3 1997M5 1997M7 1997M9 1997M11 1998M1 1998M3 1998M5 1998M7 1998M9 1998M11 1999M1 1999M3 1999M5 1999M7 1999M9 1999M11

Source: IFS

that Indonesia's government decided to request IMF assis-tance.

The financial and the corporate sector was confronted with an increase in the rupiah value of their foreign indebt-edness. Most private companies were able for some time to cover their foreign exchange losses but they were dramati-cally running out of cash, unable to refinance their short term debt and watching it rapidly expanding (banks and for-eign creditors refused to rollover the existing short term debt). On the other hand, banks were unable to crack down on their debtors because of a weak and inefficient bank-ruptcy law. This, together with tight liquidity and high inter-est rates, gradually pushed many banks and companies into technical bankruptcy. At end-October, rating agencies downgraded the ratings of 10 big Indonesian banks from neutral to negative, further limiting their borrowing abilities.

The already poor confidence in the national banking system brought about a gradual build-up of runs on some of the pri-vate banks, reflecting a "flight to quality", as depositor per-ceived state banks to be safe and were moving deposits from presumably troubled private banks. As a result of a cri-sis, the stock market index immediately lost 30%, and then a further 10%, before November 1997 because investors lost confidence. The real estate market collapsed as well.

Office, residential and retail property rent and prices (usual-ly quoted in USD) fell from 30% to 80% between June 1997 and June 1998.

On October 31, 1997, the IMF unveiled the 23 bln USD aid package for Indonesia and on November 5 approved a 10 bln USD standby loan facility. Apart from a request for

structural reforms and tight monetary and prudent fiscal policy, the package included the requirement for the closure of the 16 most insolvent (bankrupt) banks. Authorities, however, failed to extend appropriate deposit guarantees and a panic erupted among depositors running the whole system [24]. A massive and sudden withdrawal of deposits started, a large number of banks failed to meet their obliga-tions and had to resort to central bank liquidity support.

One reason for a sudden drop in overall confidence was that people saw the end of the regime approaching quickly.

They doubted the political capacity of the government to fulfil its commitments to the IMF. In the beginning of Decem-ber 1997, Soeharto was ordered to retire to bed and disap-peared from public life for about a month. The implementa-tion of IMF packages was already delayed or off-track. The rupiah collapsed badly to almost 6000 IDR/USD. Soeharto reemerged in public on January 6, 1998, only to unveil the 1998/1999-draft budget that had virtually nothing to do with the reforms agreed upon with the IMF. At that moment, confidence in the Indonesian government was lost com-pletely and on black Thursday, January 8th , the rupiah plum-meted to 10000 IDR/USD – and later even to 14000. The market panic across the country in anticipation of food shortages and overall social unrest and violence started.

Food prices skyrocketed indeed and through 1998 increased by 100%, compared to 70% of total CPI increase.

Financial panic continued, the surge in liquidity provided by BI to tumbling banks (about 7% of GDP before end-Janu-ary) far exceeded the real liquidity needs of the economy and contributed to sharp rise in inflation and put further

[24] Authorities guaranteed only deposits up to about 5000 USD. The guarantees covered 90% of depositors but not even 20% of total deposits.

However, the lack of confidence in banking system was so great that there were hardly any awareness of any deposit guarantees (or belief in such guar-antees) – depositors with deposits less than 5000USD were also running on banks.

Figure 5-18. Indonesia: Inflation annualized

0 10 20 30 40 50 60 70 80 90

1996M1 1996M5 1996M9 1997M1 1997M5 1997M9 1998M1 1998M5 1998M9 1999M1 1999M5 1999M9

Source: IFS

downward pressure on the rupiah – the inflation-devalua-tion spiral began. In order to stop the bank runs, on January 26, 1998, the government announced a blanket guarantee for all deposits as well as the establishment of a banking sec-tor restructuring institution.

Such a massive depreciation had a devastating effect on the balance sheets of banks and companies. By December/January, many of them already quietly stopped paying back loans. The overwhelming majority of banks became paralyzed with an average of 50–70% share of non-performing loans. The debt moratorium on corpo-rate debt payments announced on January 27, 1998 was the official confirmation of this and was met with mixed reception, but also with relief that any actions were taken at all. In the meantime, on January 15, the second agree-ment with the IMF was concluded – previous reform claims were reiterated but the policy somehow eased as the seriousness of the crisis has been realized. After these measures, the rupiah stabilized and moved within 8000–10000 IDR/USD band from end-January to the beginning of May.

Tight financing conditions, heavy burden of debts, cash-shortages, negative wealth shock connected with rapid depreciation of asset prices, political instability and uncer-tainty about the future of the regime, social and ethnic ten-sion, accelerating inflation and general uncertainty about the prospects for the economy were the main reasons for the sharp domestic demand contraction. Individuals, expecting tough times, postponed consumption and switched to sav-ings. The corporate sector halted or delayed investment plans. Consumption fell by 9% and investment by 45%. A decline in demand and damage to production and distribu-tion facilities caused by social unrest contributed to a sharp contraction of economic activity, the most severe in con-struction (-37% from 1997 to 1998) and financial, rental and corporate services (-58%). The total output declined in 1998 by 14%. Both exports and imports fell but import con-traction was much more severe (-49.4%) and was a reason for achieving a current account surplus of 3.8% of GDP in 1998. The surplus (net external demand) however was by no means sufficient to offset the fall in domestic demand.

The surplus in the capital account was caused by a large Figure 5-19. Indonesia: Consumer prices

0 50 100 150 200 250

1996M1 1996M5 1996M9 1997M1 1997M5 1997M9 1998M1 1998M5 1998M9 1999M1 1999M5 1999M9

Source: IFS

Table 5-3. GDP growth decline components in 1998

Component Growth % in GDP decline

Domestic demand -17.6 134

Private -2.9 13

Consumption

Public -14.4 8

Investment -40.9 96

Stock changes - 17

External demand - -34

Export 10.6 -21

Import -5.5 -13

Total GDP -13.7 100

Source: BI and Cental Bureau of Statistics

inflow of official aid, while the outflow of private capital was not reversed. Inflation escalated to the level of 80% in 1998 in response to panic food buying, interrupted production, social violence and increased prices of import commodities.

Unemployment rose from 5% to 28% at end-1998.

On March 10 1998, Soeharto was reelected to a 7th term in office. On May 4, the government announced sharp price increase of gasoline and other utilities. Widespread protests erupted, among them most importantly student-led anti-regime demonstrations calling for the President's resignation.

The army cracked down on protesters. Embassies and for-eign companies evacuated non-essential staff. On May 19, dents started parliamentary compound occupation. The stu-dent demonstrations seeking political reforms were accom-panied by rioting, widespread looting, destruction, crime, as well as religious and ethnic conflicts. Anti-Chinese rioting directed mainly at shopkeepers in small town resulted in complete disruption of supply distribution channels and short-age of basic products. The general erosion of social order went out of control. Over 1000 dead were reported in the May riots. The hard-won relative stability of the rupiah was immediately lost, runs on banks and massive deposit with-drawals started again, the currency crisis renewed and the rupiah plunged to over 16000 IDR/USD. It took five months to bring it back under 10000 IDR/USD. On May 21, urged by his affiliates, Soeharto resigned.

Changes in key positions in the administration con-tributed to delays in the implementation of economic reforms. With reference to that and to harsh economic cir-cumstances, the IMF rearranged its agreements with Indonesia towards easier conditionality. The situation start-ed to stabilize. Food security has been gradually restorstart-ed through emergency import and increased food subsidies.

Monetary stability gradually returned around October 1998, inflationary pressure eased and the rupiah stabilized around 9000 IDR/USD. Price levels also finally stabilized and the beginning of 1999 saw some deflation. The sluggish process of financial system and corporate debt restructuring started.