Causes of the Indonesian Financial Crisis

Causes of the Indonesian Financial Crisis

When the financial crisis hit Asian countries in mid-1997, Indonesia did not escape the impact. It became one of the worst hit countries during the crisis. The question to be answered is what really caused Indonesia, which at the time had a magnificent economic growth to collapse along with most of Asian countries. This paper studies the factors that may be causing the crisis and how the combination of them could lead to such crisis.

Indonesia's Economy before the Crisis

- Indonesia under the governance of President Suharto was considered a growing and vastly developing country, with a 7.9% growth in GDP in 1996. GDP per capita first surpassed $1000 in 1995, growing significantly from mere $70 thirty years ago. Total GDP was US$227 billion in 1996. (exhibit 1)

- Surplus on merchandise trade through the 1980s and 1990s. Manufactured exports grew from less than US$1 billion in 1980 to more than US$9 billion in 1990. In 1996 total exports was US$49.8 billion, with a growth of 9.7% from the previous year. 76.5% are from non-oil and gas exports. Main destinations were Japan followed by USA and Singapore.

- In 1996, imports totaled US$42.9 billion, grew 5.7% from the previous year.

- Indonesia was the third-largest FDI recipient in the Asia Pacific, averaging over US$31 billion per year from 1994 to 1996. In 1997 before the crisis, FDI was US$16 billion.

- In 1991, foreign debt increased 66% from 1988. In 1992, the total was US$80 billion, 30% was private commercial loans. (exhibit 2)

- Low inflation and stable currency. Relatively low unemployment of 4% out of 85 million workforces.

Contributing Factors

- Companies and financial institutions borrowed in foreign currencies mainly US dollars and Japanese yen since interest rates were low compared to rupiah. These loans were obtained without hedging the currency risk, because many believed that the pegged exchange rate would protect from foreign exchange risk. Most of them were short-term loans; the total can be as high as US$85 billion to US$115 billion.

- Continuing excess demand. Account deficit increased from 1.6% in 1994 to 3.2% of GDP in 1995.

- Corruption within the government was high. Transparency issues in the government with several people especially the President's sons and daughters controlled many major companies in Indonesia.

- Weak legal and regulations for the financial system. Lots of unhealthy banks running on very low capital.

- Indonesian central bank (Bank Indonesia) had allowed rupiah to float with a range of 8% allowing a 4-5% annual depreciation from 1995. This band would later be increased to 12%.

The Asian crisis started on July 2, 1997 when the Thai government floated the baht from 25 to 35 per US$ triggering a contagion that spread throughout South East Asia.

To sum it up, Indonesia economy during the crisis fell due to:

- Pressure on the regional currencies initially did not hit Indonesia really hard, the large account deficit and foreign debt in US$ seemed to not affected Indonesia much. Indonesia also had allowed the currency to float within a band since 1995. When other regional currencies started to decline in 1997, Bank Indonesia increased the band to 12%. In August, rupiah fell below the 12% band. This forced the central bank to float the currency freely. This in turn caused panic among many companies with foreign debt denominated in US$.

- These companies had high amount of debt in US$ with a short due date, and most of them were rushing to pay, so they were selling rupiah for dollars further depreciated the rupiah. In October, the rupiah was at 3500 for a US$1.