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

ETHOS Issue 03, Apr 2010

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.

Do you disagree with critics like Jeffrey Sachs who argue that the IMF measures were incorrectly prescribed and exacerbated the crisis?

There is some validity to that view. But my own view is that the IMF had few choices to the path it took. Hypothetically speaking, if the IMF had adopted a much more hands-off approach, I am not sure things would have been better. The IMF did not create the economic weaknesses which left Indonesia vulnerable to a financial crisis in the first place, nor the country’s personalised form of government, which made responding effectively to the crisis so difficult. The IMF certainly made mistakes in assembling the stabilisation packages in October 1997 and January 1998, but these were not, in my view, the main determinants of the crisis. Far from it.

Could things have been better? Certainly some public relations could have been undertaken to forestall capital flight after the bank closures were announced in October 1997. But this was something the Indonesians needed to do, not the IMF. At any rate, the bank closures did not work because Suharto’s children were reopening those banks under different names within two weeks. Everyone knew that the people who owned the closed banks were far more politically powerful than the Central Bank as regulator. So they had strong suspicions that legal lending limits and other legal requirements were not being respected and, as it later turned out, all the suspicions were absolutely right. It is not right to pin the blame for this on the IMF.

One little discussed aspect here is the role of Suharto’s economic technocrats. They well knew about the structural deficiencies and the damaging roles played by Suharto’s cronies but were not politically strong enough to stop these activities. But the financial crisis presented an opportunity for them to address some of these deficiencies. The IMF did not on its own come up with the list of 50 structural reforms which formed the heart of the January 1998 stabilisation package. That list was very similar to the technocrats’ wish list of things they would have liked to do but could not do for political reasons. Understandably, the IMF relied heavily on the technocrats for identifying the key reforms to extract Indonesia from crisis.

In sum, when you look back at the financial crisis in Indonesia, you cannot separate it from the political crisis. After October 1997, it became increasingly unlikely that Indonesia could solve its burgeoning crisis through financial measures alone.

A lot has changed in Indonesia, but would it now be able to ride out a similar crisis? What key political and economic challenges will Indonesia still have to address?

Economically, Indonesia has struggled to return to pre-crisis growth levels. For example, it has not benefited as much as it could have from the global commodities boom, which should have drawn far more investment into its oil, gas, nickel, copper and gold mining industries, among others. On the contrary, Indonesia has gone rapidly from major oil exporter to net oil importer. The decentralisation programme is partly at fault here. The regions do not have the capacity in terms of government institutions that the central government has to exploit these economic opportunities. Additionally, Indonesia has a long way to go in strengthening laws and policies to promote economic development—there remain many statutes on the books that deter legitimate businesses and scare away capital.

But Indonesia ten years on is a lot less vulnerable to the kind of financial crisis we saw in 1997 and there are several things to note in this respect. First, there is greater transparency in the system. We know more of what’s going on, probably not quite as much as one would like, but certainly a lot more than we did pre-crisis. Second, economic institution-building is underway. There is an oil and gas sector regulator, a telecommunications sector regulator and a strengthened capital markets regulator. A strong law preserving independence for the Central Bank was passed.

Third, the gradual transition to direct elections at the national, provincial, district and municipal levels is building more transparency, accountability and trust into the political system, even if progress is far slower than many Indonesians would like. And, finally, the anti-corruption campaign of the current president, Susilo Bambang Yudhoyono, has finally begun to make inroads into an important problem that has bedevilled Indonesia since its independence. Ten years post-crisis, Indonesia’s economy is a lot less flashy but considerably more stable.