Ethos Issue 3, Oct 2007

Indonesia in the Financial Crisis: Advent and Aftermath
Interview with Adam Schwarz

In your book A Nation in Waiting: Indonesia’s Search for Stability, you argue that Indonesia suffered more than any other country in the Asian financial crisis not because its economic situation was more dire or because the International Monetary Fund (IMF) had prescribed the wrong kind of solution, but because the country’s political system was “fatally flawed”. Could you elaborate?
What distinguishes Indonesia’s experience from that of, say, the Thais, Koreans or Malaysians is the fact that Indonesia essentially went through three major crises more or less at the same time. It went through a financial crisis not dissimilar to that experienced by the other Asian countries. It had a balance sheet mismatch at the national level in the sense that it had excessive dollar-denominated liabilities. It had weaknesses in the banking system from a regulatory point of view. And then, when the currency slipped, the banks were vulnerable and the companies that had borrowed cheap dollars were caught in a bind. That story is not dissimilar to some of the other countries that suffered from the financial crisis although there were some important differences.

The second was a political crisis. There was a change of administrations in Thailand and in Korea during the crisis as well as considerable political tension in Malaysia between then Prime Minister Dr Mahathir and his deputy Anwar Ibrahim. But what one saw in Indonesia was not so much a change of administration as a change in the form of government. Indonesia had had thirty-three years of authoritarian rule, during which many “modern” political and economic institutions, ranging from parliaments and supreme courts to regulatory bodies and watchdog agencies, were either not present or had been badly eroded. When you switch overnight from an entrenched authoritarian regime to a new system of government, the transition can be traumatic. Indeed, ten years on, Indonesia is still trying to develop the basic infrastructure to run a modern democracy effectively.

The third crisis that Indonesia experienced happened a little later—around 2000/2001—and it was related to the second crisis. Jakarta, once the omnipotent centre of power, came under increasing pressure to share the spoils of power. Laws passed at that time devolved considerable economic and political power from Jakarta to the regions. But the regions were not institutionally prepared for such a delegation of power. There were no functioning bodies at the provinces and districts that could handle large-scale investments or taxation, for instance. The provinces and districts were starved for money as the centre was not dispensing the finances that it had said it would under the law. On the other hand, when the regions did receive the promised monies they failed in many cases to deliver public services effectively. This in turn deterred both domestic and foreign investment and led to an increase in corruption.

In short, there occurred, in a very short period of time, three fundamental transitions: from a healthy economy to near insolvency; from authoritarianism to democracy; and from an all-powerful Jakarta to a more decentralised system of government. And, in my view, that’s why Indonesia’s situation was worse by orders of magnitude than the other financial crises in the region.

That explains why Indonesia took a longer time to get out of the crisis, but what factors made Indonesia vulnerable in 1997?
In May 1997, at the beginning of the crisis when the Thai baht first devalued, the conventional wisdom was that Indonesia was not going to be seriously affected. In fact, some economists argued at the time that because strong fundamentals were in place and economic management was in safe hands, the rupiah would remain stable or even appreciate.

Obviously, it did not turn out that way. The rupiah started to weaken in July/August of 1997. An IMF package was worked out in October 1997, which, at that time, was pronounced impressive. Among other things, the package called for the closure of some weak-performing banks. However, President Suharto’s children and some of his close allies started to undermine the package almost immediately by trying to get exceptions for their business interests. The message this sent—that the political needs of the Suharto family trumped broader economic considerations—was extremely damaging because it undermined the assumption that Indonesia’s economy was in good hands. In January 1998, Indonesia agreed to a new reform package with the IMF which finally recognised that the country was in crisis mode. However, Suharto immediately started to undermine that agreement also, signalling to the markets that his stance had not really changed. Things started spiralling out of control thereafter.

At that point, the Central Bank was just funnelling money to the banks instead of closing them down for violating legal lending limits. The lack of financial prudence in lending at many of the large, conglomerate-owned banks created a vicious cycle of bad monetary management, spiking the money supply and inflation, which in turn worsened the currency depreciation.

On the political front, crisis management was in bad hands. Suharto by that time was almost completely cut off politically, surrounded by confidantes and loyalists, and was seemingly unaware of the magnitude of the financial crisis facing Indonesia.

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