Indonesian Macro Policy Through Two Crises.

• Author: Azwar, Prayudhi

1. Introduction

   Indonesia has an open, developing economy that has been affected, occasionally dramatically, by shocks from abroad. The most substantial of these was the Asian Financial Crisis (AFC), which was transmitted from elsewhere in Asia via financial markets, eventually precipitating capital flight and a full run on the Indonesian currency (McLeod 1998; Berg 1999). The result was an extraordinary currency depreciation, a loss of financial stability and a dive in overall macroeconomic performance. In spite of its external origins, and in part because of the coincidence of an initially misdirected policy response and a reversal that triggered a panic and domestic political upheaval, this particular crisis left Indonesia with remarkably poor performance relative to all the countries affected (Djiwandono 2007).

   By contrast, during the Global Financial Crisis (GFC) a decade later, when most nations slumped into recession on the heels of the financial collapse in the US, the Indonesian economy slowed but did not recess, achieving real growth of 6.1 per cent in 2008 and 4.5 per cent in 2009. Indeed, the country's real GDP growth in 2009 was the third strongest in the G20, after China and India (OECD 2010). Two associated issues are addressed in this paper. First, this contrast in performance is seen to have two origins. On one hand, there were differences in the size and maturity of the economy over the intervening decade, and in the composition of the AFC and GFC shocks. More importantly, in our view, Indonesia's macroeconomic policy regime at the time of the AFC was unsustainable during a capital flight, leading to a policy reversal and an associated loss of confidence, which precipitated an extraordinary depreciation, large rises in debt service burdens, insolvencies and the temporary sequestering of physical capital. This clearly contributed to political upheaval, which further eroded confidence at the time.

   Second, since both crises had elements of capital flight, with bond spreads indicating initial rises in investment risk premia of similar magnitude, this paper seeks to decompose the policy responses and identify the specific macroeconomic regimes that led to their ultimate resolution. Although there was some repatriation of foreign currency reserves in each case, this analysis suggests that the key elements were currency depreciations combined with fiscal expansions that depended, at least partially, on borrowings from Bank Indonesia, or money financing (Basri 2012). Indonesia's government entered the early stages of the AFC under pressure from the IMF to defend its de facto fixed exchange rate, reduce key subsidies and close insolvent banks, all of which proved to be contractionary in the ensuing capital flight, eventually engendering reversal and a currency float. Yet, at the time of the GFC, there was no policy reversal towards this regime. Having learned from its AFC experience, the Indonesian government implemented the policies that eventually worked in the GFC immediately. This was, however, also accompanied by a substantial depreciation, a rise in inflation and some labour dislocation, but these effects were far more moderate than their counterparts during the AFC.

   The macroeconomic analysis applied here is based on an elemental economy-wide model that simulates interlinked changes in the labour market, the financial capital market and the markets for home money and foreign exchange. It is constructed in the Mundell (1963) -Fleming (1962) tradition, as updated by McCallum and Nelson (1997), with flexible price levels and expectational shocks. This conventional technique, applied to completely separate databases for 1996 and 2007, allows the decomposition of the effects of both external shocks and domestic policy responses so that relative contributions of each can be estimated.

   The section to follow offers a short outline of events surrounding the AFC, while the third section provides similar background in the case of the GFC. The model used is detailed in the subsequent section, and the analysis of component AFC shocks and their impact is presented in the fifth section. The corresponding analysis of GFC shocks is presented in the sixth section, and the final section concludes.

2. The Asian Financial Crisis (AFC)

   The AFC occurred during a period of strong performance in the advanced economies outside Asia, driven by the US information technology (IT) boom. Even in the Asian region, the Chinese economy grew strongly, as did that of Australia. As Figure 1 shows, asset markets were also strong in the leadup, even during the crisis, at least for those economies not directly affected by it. The apparently sound macroeconomic conditions prevailing prior to 1997 saw almost no economic experts predict that the AFC would cut the Southeast Asian economies in general, and Indonesia's economy in particular, so deeply (Hofman, Rodrick-Jones, and Thee 2004). Indeed, the World Bank had just published its spectacular tome, The East Asian Miracle: Economic Growth and Public Policy, lionizing the policy regimes of the East and Southeast Asian governments (MacDonald 1993) (1) and Hal Hill's detailed analysis of the Indonesian economy, again with an optimistic tone reflecting the strong performance of the earlier 1990s, had emerged the year before the crisis (Hill 1996). The irony is evident in the title of the first book on the crisis to emerge afterwards: East Asia in Crisis: From Being a Miracle to Needing One (McLeod 1998).

   The origins of the crisis were manifold, combining weakly supported US dollar pegs in Southeast Asia and Korea with the rapid expansion of competitive Chinese exports. Chinese competitiveness was supported at the time by its new (since 1994) US dollar peg and a depreciating underlying real exchange rate due to rapid Chinese reserve accumulation (Tyers, Bu, and Bain 2008). (2) An immediate trigger was a real depreciation of the yen relative to the US dollar, which was associated with a policy switch from monetary contraction to expansion in Japan as it struggled to deal with the banking crisis that underlay its first decade of stagnation (Horiuchi 1998; Tyers 2012). The considerable effect of this switch on the value of the yen, illustrated in Figure 2, proved important in Southeast Asia because Thailand and Indonesia, in particular, had received extensive foreign direct investment (FDI) from Japan since the 1980s. This was investment of the outsourcing type, which saw both countries depending increasingly on exports to Japan rather than to the US, notwithstanding their US dollar pegs. The strength of Indonesia's dependence on exports to Japan is evident from the export shares also shown in Figure 2. Further evidence of this can be seen from Figure 3, which, despite the beginnings of a depreciating trend against the US dollar, shows a sharp appreciation of the Indonesian rupiah against the yen just prior to the AFC.

   Despite the immediate negative shock emanating from Japan, and the associated drop in exports destined for Japan illustrated in Figure 4, redirection to such destinations as China ensured that there was no significant net export demand shock. Instead, the Japanese depreciation and its effect on the terms of trade directed attention to fundamental problems with the Thai and Indonesian de facto US dollar pegs, undermining the confidence of domestic and foreign investors. Financial collapse began in Thailand and spread quickly to Indonesia, taking the form of an increase in the risk premium on Indonesian asset returns, precipitating a capital flight that developed into a run on the Indonesian currency, widespread insolvency in the manufacturing and financial sectors, followed by shut-downs and the sequestration of manufacturing capital.

   Indonesia's particularly deep crisis could be seen as rooted in a combination of external and internal problems. As for other affected countries, these included adherence to Indonesia's de facto US dollar peg. Financial yields inside the Indonesian economy were higher than those abroad, due primarily to regime risks perceived externally, as indicated in Figure 5. Yet, the exchange rate peg created moral hazard, which led Indonesian investors to borrow abroad at lower rates (Corsetti 1999). The volume of this debt eventually proved too large for the central bank to protect with the foreign reserves available. A complicating factor was the rise in short-term foreign currency debt, which was mostly unhedged and characterized by "double mismatch" (maturity and currency). These issues sat alongside particular weaknesses in Indonesia's commercial banking sector at the time. It carried high levels of non-performing loans, along with short-term debt denominated in domestic and international currencies. (3)

   The composition of Indonesia's foreign liabilities is suggested by the investment flows on its balance of payments illustrated in Figure 6. Portfolio flows are clearly more volatile than FDI and, during the AFC and the GFC, there were considerable net outflows. (4) Yet, the level of gross external debt, relative to national income, which rose unprecedentedly during the AFC, has been stable at half its pre-AFC level since then, as indicated in Figure 7. While the preponderance of portfolio liabilities did make a financial retreat easier, we see this as arising out of the moral hazard and the structural problems that inhibited Indonesia's attractiveness as an investment destination at the time.

   The "microeconomic reform" tradition had swept the advanced and developing world in the late 1980s and early 1990s and many countries embarked on the abrupt liberalization of their financial industries, inviting offshore capital movements. Indonesia was no exception, but its capital inflow was comparatively large, causing a considerable surplus on the capital account, booming investment and strong consumption demand. These factors raised the current...