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Bulletin of Indonesian Economic Studies

ISSN: 0007-4918 (Print) 1472-7234 (Online) Journal homepage: http://www.tandfonline.com/loi/cbie20

J. Soedradjad Djiwandono, Bank Indonesia and the

crisis

Stephen Grenville

To cite this article: Stephen Grenville (2006) J. Soedradjad Djiwandono, Bank

Indonesia and the crisis , Bulletin of Indonesian Economic Studies, 42:1, 105-112, DOI: 10.1080/00074910600632419

To link to this article: http://dx.doi.org/10.1080/00074910600632419

Published online: 18 Jan 2007.

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Review Article

J. SOEDRADJAD DJIWANDONO,

BANK INDONESIA AND THE CRISIS

Stephen Grenville

Australian National University, Canberra, and Lowy Institute for International Policy, Sydney

Soedradjad Djiwandono, Governor of Bank Indonesia during the critical early months of the Asian crisis, had already written extensively on the period (includ-ing in this journal), but this book br(includ-ings a more comprehensive version of his story to a wider audience. His focus is on central bank issues—the exchange rate, interest rates, capital ﬂ_{ows and the insolvency of the banking system—but}

as these are the deﬁ_{ning issues of the crisis, the book provides a rare and}

valu-able contribution to the still-incomplete history of this painful period. This review puts his account in context and offers some commentary on the issues.

While the introduction describes it as a revised English version of Soedradjad Djiwandono’s 2002 book, Mengelola Bank Indonesia dalam Masa Krisis (Managing Bank Indonesia during the Crisis, reviewed in BIES in August 2002), this volume not only makes the story available to a wider audience, but offers a substantial re-write of the earlier book. It also provides more detailed discussion than was given in Djiwandono’s two articles in the BIES (April 2000 and April 2004). The book will be of great interest to those who see the Asian economic crisis of 1997–98 as a watershed whose adverse consequences are still felt strongly today. While there has been time for reﬂ_{ection and perspective, there remain many controversies and}

unresolved issues.

The author was governor of the central bank during the critical opening phase of the crisis and thus was a central player in the events. There are, inevitably and understandably, personal views and interpretations of the events which might be seen as a defence of actions taken. As well, there are omissions in areas where the author may know much more, but has chosen to remain silent (one possible constraint being the threat of prosecution that hung over many of the key play-ers in the drama). With these constraints, this book will be just one element in the overall body of evidence needed to write the history of the period. But the invaluable compensation is that this is written ‘from the front line’, by a major participant during the period in which Indonesia deviated from the path of the other crisis countries of East Asia. The sacking of Djiwandono in February 1998 coincides with the darkest period of the crisis, so his eye-witness account covers the most critical and interesting period. It provides fact and context but, more

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106 Stephen Grenville

importantly for history, it provides viewpoint: particular insights into the policy decision-making process and the politics of the time.

Outline

The prologue to the book provides a deeply personal account of the author’s dis-missal by former president Soeharto (especially interesting because he is related to the latter by marriage). Much of the story is chronological, with chapters on the origins of the crisis, the early policy programs and their failure, and the ‘stronger programme with weak commitment’ (describing how the IMF had developed a program with many elements of conditionality that were not, in practice, accepted by the president) (p. 163). The issues speciﬁ_{c to Bank Indonesia (BI) are covered in}

a detailed chapter (including the central issue of independence), and the overall lessons of the crisis drawn in the concluding chapter. An epilogue brings some of the policy-oriented discussion together, discussing the multi-dimensional and protracted nature of the crisis and offering further speciﬁ_{c comment on exchange}

rate management.

Policy content

Critical and far-reaching decisions were taken in the initial phase of the cri-sis, before the substantive involvement of the IMF towards the end of October 1997. Djiwandono provides a reminder of the context: at this stage, there was a unanimous and conﬁ_{dently held belief that the problem was relatively small.}1

As Thailand’s crisis unfolded in the ﬁ_{rst half of 1997, it was seen as a different}

case, where policy had been less well managed. Indonesia was still conﬁ_dent

that its sound macro policies would protect it from a major change of senti-ment, and the exchange rate was not judged to be signiﬁ_{cantly over-valued. The}

rupiah had been under pressure to appreciate rather than depreciate, and over time the exchange rate band had been widened to allow the rate to move fur-ther without the need for ofﬁ_{cial intervention. The assessment was that an IMF}

borrowing would not be necessary, and the only reason for involving the IMF was to get a ‘seal of approval’ on Indonesia’s own actions. Indeed, Djiwandono argued speciﬁ_{cally for a precautionary IMF program (which might have been}

more palatable politically), with the implication that actual funds would not be drawn (pp. 64, 74).

With this mind-set, Indonesia responded by drawing on past successful actions. The exchange rate band was widened in July 1997, to give more room for the rate to move without requiring the central bank to use reserves in its defence. Thai-land was seen as having made a serious error in exhausting its foreign exchange reserves in the defence of the baht. On 14 August, the rupiah was ﬂ_{oated, not}

because of force majeur (as in Thailand), but as a culmination of the policy of grad-ually widening the intervention band. What Djiwandono’s book makes clear, however, is just how unexpected, even startling, this action was (p. 44). Businesses were accustomed to movements in the exchange rate—both gradual depreciation and the large ‘one-off’ changes that occurred during the previous decade or two.

1 For an example of this view, see the BIES ‘Survey of recent developments’ of August 1997, which contains a box titled ‘Why Indonesia Is Not Thailand’ (Feridhanusetyawan 1997: 8).

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Bank Indonesia and the Crisis

Those businesses that had borrowed in dollars did not, however, expect to be left to their own devices, with no limits on the extent of exchange rate movements. Perhaps with hindsight, Djiwandono’s own implicit view suggests that it was a mistake to move suddenly to the ‘shock therapy’ of a free ﬂ_{oat (pp. 39, 223). Those}

who had borrowed in foreign currencies attempted to hedge their exposure, and speculators joined the rush for the exit, driving the currency down further in the process.

Another ‘tried and true’ initial response to the crisis, taken a few days after the

ﬂ_{oat, was to cut available liquidity sharply, squeezing the banks. The precedent here}

was the earlier ‘Sumarlin shocks’ (Cole and Slade 1996: chapter 3), in which state-owned enterprises (SOEs) were instructed to withdraw their bank deposits and use them to buy central bank certiﬁ_{cates (SBIs)—in effect a contractionary open market}

operation. The operational aspects of the banking system had, however, changed. Banks no longer held large compulsory reserves that could buffer the sudden with-drawal of liquidity. By 1997 ﬁ_{nancial deregulation had almost eliminated required}

reserves, and the withdrawal of SOE deposits left the banks without enough liquid-ity to meet either their small reserve requirement or, more immediately, their daily cheque-clearing obligations in the payments system. Djiwandono is clearly uncom-fortable with this key mistake, which he says was made by the Minister of Finance, who was chairman of the Monetary Board (pp. 204, 206).

At the same time, substantial foreign exchange intervention in the defence of the rupiah also withdrew liquidity. In response to the illiquidity, BI began provid-ing lender-of-last-resort funds (later called Bantuan Likuiditas Bank Indonesia or BLBI). There was certainly a pressing need to add liquidity back to the system, but the operational means by which this was done were badly ﬂ_{awed. Djiwandono’s}

defence of BLBI is largely in terms of the legalities (an understandable preoccupa-tion, considering that three very senior BI ofﬁ_{cials are serving substantial gaol}

sen-tences for their part). But he makes a rather ineffectual defence against the damning auditor-general’s report. In the opinion of this reviewer, that report was a narrow and legalistic accounting compliance exercise, taking no account of the nature of the lender-of-last-resort function and the magnitude of the crisis disruption; Dji-wandono might have been more explicit, forceful and detailed in addressing its weaknesses. Perhaps more seriously, he says nothing of why the administration of the BLBI seems to have been so poorly handled. In exchange for the liquidity sup-port, BI received personal guarantees from the owners of the banks, but it did little to take operational control of the borrowing banks, so as to prevent the funds from being misused to provide loans for currency speculation or asset stripping. For this reviewer, managing widespread bank failure is something that few central banks are adequately prepared for, and there are few opportunities to gain practical expe-rience. That said, BI’s patent inadequacies in the administration of the BLBI require more explanation than Djiwandono gives here.

Above all, there seems to have been an unresolved conﬂ_{ict in the minds of the}

central players. On the one hand there was the need to provide liquidity to keep the banking system and the payments system functioning, and on the other there was the need for a tighter monetary stance through high interest rates to support the currency. Juxtaposing this with the commercial sector’s unfolding insolvency as the exchange rate fell ‘put Bank Indonesia in an impossible posi-tion’ (p. 113).

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By October the IMF was deeply involved, with the ﬁ_{rst step, the closure of}

16 small banks, announced at the beginning of November. Djiwandono clearly feels the IMF should have been less conﬁ_{dent that closing these banks could be}

done without triggering a general run on banks (pp. 119, 130). He is critical of the absence of full depositor protection when these banks were closed.2 Two of the closed banks had close connections with the president’s family, so their clo-sure had more importance than their size suggests. When the owners resisted the closure, apparently with presidential blessing, this was especially damaging to conﬁ_{dence. Getting detail onto the historical record is an important part of the}

Djiwandono story—he ﬁ_{rmly asserts that the president had prior knowledge that}

these well-connected banks would be closed, and acquiesced by implication. The outcome: ‘The bank closures[,] aimed at winning back market conﬁ_{dence in the}

banking sector, caused the reverse effect’ (p. 109).

There is interesting insider’s background on the proposal, made in early 1998, for Indonesia to replace its ﬂ_{oating currency regime with a currency board}

sys-tem (CBS). Here the overwhelming impression is one of chaotic and unstructured decision making. By this time the president had lost conﬁ_{dence in the economic}

team. Steve Hanke, a long-time proponent of currency boards, was invited (per-haps by business interests close to the president) to provide advice directly to the president. In the opinion of this reviewer, a CBS would have been inappropriate to Indonesia’s ﬁ_{nancial structure: it relies on an automatic tightening of interest}

rates to discourage capital outﬂ_{ow, and has been used where the provision of}

domestic bank credit is based on a credit-multiplier process. In the Indonesian context with small bank reserves, however, even a modest net demand for for-eign exchange would have left the banks without enough funds to clear their cheque payment balances. They would already have been illiquid before higher interest rates could have any impact in restraining the demand for foreign cur-rency. The close involvement of the president’s family provided irresistible pres-sure to set a rate that was favourable for those with foreign debt, and Rp 5,000/$ was commonly cited as a possible rate (including by Hanke, see p. 10). At such a rate, the CBS would have broken down on the ﬁ_{rst day. These analytical}

arguments were, however, poorly presented. While he was opposed to the CBS, Djiwandono says that he was afraid to air his views in public and that ‘being vague was the best technique in that environment’ (p. 10). The case against the CBS was largely technical, however, and required analytical rigour and clarity rather than subtle circumlocution. With business interests seeing short-term per-sonal gains, various factions in the bureaucracy supporting the idea for political reasons, and the IMF initially unable to mount an effective counter-argument, this idea held centre stage in the policy debate at a crucial moment when the impor-tant issues were slipping out of control.

The policy-making process

In describing the way decisions were made in the ‘fog-of-war’ of the crisis, Dji-wandono may be making his main contribution to our understanding of this period. The long-serving ‘technocrat’ team had undergone gradual generational transfer, with Professor Widjojo playing a more background role in the period

2 On depositor insurance, see McLeod (2006), this issue.

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leading up to the crisis. Djiwandono is, however, explicit in noting that the most senior of the technocrats—Professors Widjojo and Ali Wardhana—although ‘retired’, were still advisers and members of the Monetary Board even at the beginning of the crisis (p. 63), and that Widjojo was appointed to negotiate the initial agreement with the IMF. But detailed carriage of the arrangements was with a younger generation of economists, lacking the old team’s relationship with the president. What is clear from Djiwandono’s account is that the presi-dent quickly lost conﬁ_{dence in the new-generation economists in the face of the}

unprecedented currency fall and the botched bank closures in the early months of the crisis. He summarily dismissed more than half of the BI directors in Decem-ber 1997 without reference to Djiwandono, and personally negotiated with the IMF in January 1998. By the time the true magnitude of the crisis was clear, late in 1997, there was no concerted analytically based decision-making machinery in place. Indonesian ofﬁ_{cials found themselves caught between the demands of}

the IMF and the intransigence of the president, and were often excluded from vital meetings (pp. 148, 162). The economics coordinating minister was hors de combat through illness; outsiders with dubious reputations were being placed in key posts; and there was a constant cacophony from meretricious advisers and bureaucrats offering different and often self-serving advice. Underlying all this, the malevolent inﬂ_{uence of the president’s family was consistently}

undermin-ing the cause of good policy makundermin-ing.

In thinking about the decision-making process, the role of the IMF inevitably comes to the fore. Djiwandono’s criticism is muted, but is clear enough: ‘The IMF and its inﬂ_{exibility … certainly contributed to the problems’ (p. 113). Is}

this simple blame-shifting on his part? He speciﬁ_{cally acknowledges that}

poli-cies were the joint product of the Fund and the government, so responsibility must be shared. There is no indication that the IMF had a better understand-ing of the rapidly evolvunderstand-ing initial phases of the crisis, and in particular the fail-ure to administer the BLBI properly. Djiwandono explicitly blames the Fund for mis-assessing the implications of closing 16 small banks in November 1997 (pp. 119, 130). There is little doubt that the efforts to exaggerate the size of the for-eign ﬁ_{nancial support back}ﬁ_{red (p. 88). The January 1998 budget announcement}

caused ﬁ_{nancial markets to become concerned that the IMF would withdraw its}

support, taking the exchange rate down sharply to reach new lows. Djiwandono comments: ‘the Fund’s inﬂ_{exible requirement for a budget surplus of 1 percent}

of GDP in 1998 turned out to be a disaster’ (p. 232). He quotes damagingly criti-cal public comments by Fund staff (p. 155): ‘there was also a tendency for the Fund staff to quickly make public disclaimers about the programme’ (p. 145).

Djiwandono is equally critical of the Fund’s insistence that high interest rates would support the rupiah: ‘A high rate of interest, which may be effec-tive in the short run to strengthen the currency, could easily have negaeffec-tive implications in the long term’ (p. 247). He notes the usual criticism of the extent of Fund conditionality (without shedding any light on the possibility that many of these ideas may have originated with the Indonesian economists themselves). He mentions the Fund’s ‘lack of expertise in handling of ﬁ_nancial

institutions or legal and judicial institutions’ (p. 237) and comments also on the rivalry between the Fund and the World Bank, and the conﬂ_{icting advice}

the two bodies provided (p. 36).

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Lessons for the future

Two unresolved issues remain important for future policy making: how to reduce the vulnerability of the fragile banking sector; and how to handle the disruption of large capital ﬂ_ows.

The banking system was clearly weak to begin with. Hit by a crisis that effec-tively bankrupted many bank customers because of their foreign exchange expo-sure, even a strong banking system would have come under presexpo-sure, perhaps fatally. So how much blame does BI bear for this weakness? Djiwandono tells how BI had clearly identiﬁ_{ed problems and had been trying to close or merge}

weaker banks during the ﬁ_{rst half of the 1990s, frustrated by delays in receiving}

permission from the president, and by irresistible pressure from the bank owners (typiﬁ_{ed by the removal of an activist head of banking supervision at BI in 1993)}

(Grenville 2004: 87). In this hostile world, could BI have done more? Djiwandono implicitly says ‘no’. Is the banking sector now stronger and less vulnerable to shocks? Time will tell: prudential supervision seems rather stronger but is as yet untested, and Indonesia comes out of the crisis having spent half of a year’s GDP in supporting its banks, without changing the structure much. The enlarged pres-ence of foreign bank owners will help stability, but the continued existpres-ence of the large state-owned banks remains a key vulnerability.

The other key vulnerability was the large inﬂ_{ows of foreign capital, mainly}

com-prising unhedged corporate borrowings. Has ﬂ_{oating the exchange rate solved}

this problem? If the exchange rate had been ﬂ_{oated earlier it seems most likely}

that it would have appreciated, and the resulting over-valuation might have pre-cipitated the crisis earlier. It may be true that when a crisis is inevitable, it is better to have it early. But precipitating an immediate minor crisis in the hope of avoid-ing a later major crisis is a hard policy prescription to implement. In any case, as Djiwandono notes, ‘the real issue is not about the choice of exchange system, but about how to deal with the free ﬂ_{ows of global capital’ (p. 257).}

Djiwandono talks about the missed opportunity to do corporate restructuring earlier in the crisis. Effective action to limit the repayment of foreign loans would have reduced the pressure on the currency. For foreign borrowings by Indonesian banks, there was clearly a missed opportunity to do a stand-still along the lines of South Korea. But for the private commercial foreign debt, it is not clear what a government which (properly) was not going to bail out the creditors should do, other than encourage the parties to sit down and negotiate rescheduling of debt– equity swaps. Again, confusion on what should be done seems to have been the order of the day, with the IMF exploring the introduction of a currency guarantee along the lines of the Mexican Ficorca arrangements.

A central element of the necessary institutional strengthening relates to BI itself. The legacy of poor policy making is a heavy one. BI’s loss of reputation over the BLBI operations was followed by a formally legislated independence for the central bank. But reputational damage lingers, and the central bank’s budget-ary independence has been compromised by the BLBI settlement, which placed a large volume of zero-interest government debt in the BI balance sheet. The gaol-ing of Djiwandono’s successor (ultimately acquitted) was a further blow to the cause of central bank independence. As Indonesia tries to rebuild its institutions, the damage is still painfully evident, at least to this reviewer. Directly reﬂ_ecting

the experience with BLBI during the crisis, the new lender-of-last-resort

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dures will guard against a repeat of this problem, but these checks and balances are so convoluted that quick (and therefore effective) action seems impossible if the facility is needed in the future.

Conclusion

Does this book leave us any clearer on why Indonesia, starting with strong mac-roeconomics and an experienced team of policy makers, fared much worse than the other crisis countries? Does it clarify why, after all the institutional disruption of the crisis and its aftermath, the degree of reform seems modest? On the techni-cal side, it suggests that there was imperfect understanding of a few key issues. But much more important was the inability to bring a rational, uniﬁ_{ed and}

coor-dinated decision process to bear. What is clear is how one mistake precipitates another, and failure quickly infects the whole decision-making process. Bad luck (for example, the president’s health scare late in 1997) can be relied on to add to the difﬁ_{culties of maintaining good policy. Rebuilding more effective and resilient}

policy structures will be a slow process. Djiwandono quotes Wing Thye Woo of the University of California at Davis: ‘The main issue of the Washington Consen-sus was how to get the prices right, while after the Asian crisis it is how to get the institutions right’ (p. 196 and footnote 19, p. 271).

Of course this book leaves much unwritten, and it is hard to resist the feeling that Djiwandono could tell far more. There is little about the period after his dis-missal (other than the ongoing BLBI saga), and yet many of these issues played out over the subsequent few years in ways that are worth recounting. Covering these more fully, even as an outsider, would have added to the story. Some readers will feel, also, that the author could have told even more about the relationships between the main policy actors. Apart from the account of his own dismissal, ten-sions and conﬂ_{icts between the parties are alluded to only indirectly. Is this a}

Java-nese reluctance to be too explicit, or was the policy-making process more like a shadow-play than the cut-and-thrust that might be typical in many countries?

Churchill, in writing his history of World War II while the war was still being waged, set the proper example—key participants should write their versions in the heat of battle, blinkered and biased as they may be, so that others can later weigh and ﬁ_{lter the various accounts to distil the true history. ‘History will be}

kind to me for I intend to write it.’ We should be grateful for the successive ver-sions of Djiwandono’s story, as they will provide the raw material for history. Let us hope that more of his colleagues will take this path: so far, the central actors in the three decades of Soeharto-era economics have, by and large, not written about the experience. So this is a rare, commendable and valuable insight into the difﬁ

-culties of decision making under adversity.

References

Cole, D. and Slade B. (1996) Building a Modern Financial System: The Indonesian Experience, Cambridge University Press, Cambridge MA.

Feridhanusetyawan, Tubagus (1997) ‘Survey of recent developments’, Bulletin of Indonesian Economic Studies 33 (2): 3–39.

Grenville, S. (2004) ‘The IMF and the Indonesian crisis’, Bulletin of Indonesian Economic Stud-ies 40 (1): 77–94.

McLeod, Ross, H. (2006) ‘Indonesia’s new deposit guarantee law’, Bulletin of Indonesian Economic Studies 42 (1), in this issue.