20 Years after the Indonesian 1998 Crisis

How resilient is the Indonesian economy?

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Indonesia’s crisis of 1997-1998 marks a remarkable turning point: not only it changes the nation’s historical course through significant social upheavals, but it also dismantles how an impending economic disaster is predicted. As Indonesia has bounced back from arguably its darkest days economically since the raging hyperinflation late in Soekarno’s administration, one question remains: how did a collapse of Thai baht manage to cripple one of the world’s most promising economies which, on paper, did not show any signs of cracks?

This short essay revisits one of the worst economic disasters in post-independence Indonesia, summarizing its intertwining causes. The essay then evaluates the economy’s resilience after the crisis and flags several factors that may increase its vulnerability in the future.

Untangling the Causes

Indonesia's downfall might have been contributed by minor missteps concealed under the robust performance – the weakened foundation then catastrophically crumbled when a negative foreign sentiment encroached the economy.

Figure 1: Indonesia's GDP per capita and GDP. Taken from Presentation by Hill (2018), The Australian National University

Figure 1 above sums up the main feature of the crisis: the distinct v-shaped movement implies a sudden, drastic decline that is then immediately followed up by a momentous recovery. While a V-shaped recession is common, it is often triggered by substantial events that ultimately bring negative impacts to the robust economy: US’ recession after the September 2001 terrorist attacks, mainly fueled by a heightened security instability, represents a prime example. Indonesia itself could not fit into this rationale perfectly: a currency collapse in another country should not have caused such a damaging repercussion unless there has been an immense flaw in the economy.

A substantial flaw in the economy itself typically would have ended in a slow recovery: Japan’s “Lost Decade”, a concrete example, was caused by a systematic failure of lending regulation, leading to a massive accumulation of bad debts in its financial institutions when the market bubble burst [1]. This pile-up eventually hampered the economic rebound as funds injected were used to clean the messy debts. Indonesia, again, did not suffer the same fate although its financial institutions were embroiled in a similar situation – signified by a hefty liquidity injection (BLBI scheme) into the banking system that accounted more than half of Indonesia’s GDP.

Conditions above suggest a possible interpretation: Indonesia was not hurt by a blatant erroneous policy as experienced by Japan, nor it was bogged down by extraordinary turns of events. In fact, its downfall might have been contributed by minor missteps concealed under the robust performance – the weakened foundation then catastrophically crumbled when a negative foreign sentiment encroached the economy.

Hill (1999) thoroughly explained the accumulation and intertwining of problems hiding beneath the surface – one major contributor was the unalarmed rise of mobile capital. While Indonesia was known for its rather-huge chunk of external debt, the government was more experienced in handling public debt as it was used to fund public projects. Soeharto’s administration had also been skilful in negotiating the terms, owing to its near-crisis experience in the 1980s. However, the government had not mitigated the risks of private capital’s influx that occurred especially after the 1988 stock market deregulation. Thus, once foreign investors’ confidence started to crumble (which was the case when BOT was forced to float baht), this highly-liquid capital would be quickly streamed out, causing shocks to the exchange rate.

Figure 2: Proportion of Indonesia's External Debts, 1991-1998 (Hill, 1999)

The quasi-fixed exchange regime, implemented by Soeharto for years, compounded the issue. As the government tried to maintain its real exchange rate, resulting in high inflation and a perception of an overheated economy, it tightened the monetary policy by raising interest rates, inducing higher private capital inflow. The government’s evident commitment in maintaining real exchange rate level also gave a superficial confidence that there would not be any significant deviation (deviation, as known, was perceived as risk), prompting the debts to be left unhedged. These two factors, coupled with the government’s inexperience stated previously, increased the economy’s vulnerability towards unexpected volatility.

A pileup of external private – mostly unhedged – debt then ensued a disastrous domino effect. When the capital flight started, collapsing rupiah’s fixed-exchange rate, corporations suffered a massive debt accumulation. This then severely impacted the health of financial institutions, which had already taken a hit when the public withdrew money due to loss of confidence.

Hasty decisions made by the government did not alleviate the crumbling system either. From IMF’s mishandling of the situation through its hit-and-miss agreements, including the sudden yet unnecessary closures of banks in late 1997 that effectively accelerated the ensuing panic, to the omission of gifted economists in the government cabinet, the crisis plunged into an uncharted territory. Frustration quickly spread into other domains, most infamously the breakout of racial violence, eventually ending Soeharto’s seemingly-impenetrable rule to an abrupt end.

Indonesia's Resilience Post-Crisis

1997-98 crisis exposes the fatal flaw of Indonesia’s macroeconomic policy: a quasi-fixed exchange rate triggered a massive accumulation of unhedged foreign private capital, leaving the economy highly exposed to unfavourable external circumstances. This concern has since been quashed after Bank of Indonesia floated the exchange rate, prompting firms to hedge their debts and diversify their portfolio. Therefore, Indonesia’s businesses would be much more prepared should a similar shock reoccur.

Indonesia has also maintained a very strict fiscal rule to maintain its health; the Fiscal Law passed in 2003 requires the government to cap the fiscal deficit at 2% of GDP and debt/GDP ratio at 60% (Hill, 2007). Inevitably, these prudent measures remarkably slashed the debt/GDP ratio, shown in the figure below. Again, this policy restricts the government’s excessive reliance on foreign investment, minimizing any harsh implication from a global economic downturn.

Figure 3: Indonesia's Debt Share, 1996-2006 (Hill, 2007)

While post-crisis Indonesia has shielded itself from a negative external shock through reforms in fiscal and monetary policies, it has also unintentionally protected itself due to its lagging export. Hill (2007) and Basri and Rahardja (2010) pointed out the inefficiencies in Indonesia’s post-crisis bureaucracy. Supported by a democratic government that was still learning, stimulating projects such as infrastructure and logistics improvements could not be carried out effectively, hindering economic growth. Thus, while it experienced a slow export growth, the impact of global crisis would also be limited: Indonesia’s relatively unscathed escape from the 2008 financial turmoil is as an excellent example.

Figure 4: Domestic consumption of selected Asian countries (left); GDP and export growth of selected Asian countries, 1990-2005 (right). Notice that Indonesia has the poorest performance in export yet among the strongest in domestic demand, sparing it from the worst of the 2008 global financial crisis (Basri & Rahardja, 2010; Hill, 2007)

Indonesia, however, has managed to establish a strong domestic economy, signified by a huge consumption of domestic products – this provides a strong safety net in case the global economy falters. Nevertheless, this rather-closed economy does not imply that Indonesia will be protected from crisis in the future. Undeniably, Indonesia will participate more in global production network if it wants to become a leading economy in the region. The currently-low share of export in GDP growth, like Indonesia’s lack of experience pre-1998 crisis, might leave the government unprepared for shocks when the export volume increases: Basri and Rahardja (2010) even warned that shocks attributed by exports could be more devastating to the GDP than the domestic demand [2].

While the coziness of strong domestic economy could leave the country unprepared for a widespread integration to the global trade, it has also started to steer the government towards a protectionist policy. Using the same argument stated above, its proponents argued that an inward-looking economy was important to enable grass-root businesses to thrive due to the formation of linkages between various domestic sectors.

Strong domestic economy, Indonesia's saviour during the 2008 Global Financial Crisis, might be the unlikely source of the next recession through the breeding of complacency and more worryingly trade protectionism.

In an analysis published by Patunru and Rahardja (2015), the actual impact does not look ideal. Besides exposing domestic industries to a systemic crisis during economic downturn, protectionism has also subtly increased the domestic industries’ vulnerability, ironically, during periods of economic expansion. Figure 5 below illustrates the import content of export products in several Asian countries: out of the countries observed, strikingly, only Indonesia experienced a decline in import content in the export products.

Figure 5: Import content of export products in several Asian countries (Patunru & Rahardja, 2015)

On a hindsight, this looks favourable -- in the eyes of populist-nationalist groups, the decline symbolizes the competitiveness of domestic products. Nevertheless, Indonesian products have been relatively uncompetitive [3]. The low import content, signifying Indonesia’s poor integration in global production network, only exacerbates the issue. Besides making Indonesia’s export products less appealing, the limited import items disincentivizes innovation due to lack of competition and prevents high-quality foreign technologies to be adopted.

Following rupiah’s massive appreciation during the commodity boom, Indonesia needs to produce high-quality export items to compensate the relatively high prices. The protectionist measures certainly do not help, especially when the domestic items still lack quality. As the commodity boom subsided, manufactured goods ideally should have been the main supporter of export. However, restrained by protectionism, the goods were simply not competitive enough. When the commodity exports such as fuel plummeted, classic examples of manufactured items such as textiles barely grew. With Indonesia failing to fully capitalize on the participation within the global trade, Indonesian businesses are in a weaker position financially when the economic downturn approaches.

Figure 6: Indonesia's exports of selected sectors derived from World Bank's WITS, 2011-2016 (US$ millions)

Closing Remarks

In conclusion, Indonesia has done well in undergoing necessary reforms to its fiscal and monetary policies to maintain the country’s financial health. More importantly, it has also managed to develop a strong domestic demand which provides an additional safety net in case another crisis hits. However, as it pushes forward to become a major, competitive, and developed economy, the government must not be complacent: a much-improved contribution in global production network needs an additional risk mitigation to prevent being bogged down like its neighbours during the 2008 collapse. It must also refrain itself from getting too reliant on protectionist policies since they prevent domestic businesses to entirely unleash their potential, leaving them more exposed to future economic slowdowns.

[1] Paul Krugman (2009) explains the case in great detail in The Return of Depression Economics and the Crisis of 2008

[2] Please refer to Basri & Rahardja, 2010, The Indonesian Economy amidst the Global Crisis: Good Policy and Good Luck ASEAN Economic Bulletin, vol. 27, no. 1, pp. 87-89, for more details.

[3] See World Bank, 2013, Export Competitiveness in Indonesia’s Manufacturing Sector for the complete evaluation.

Reference

Basri, M. C., & Rahardja, S. (2010). The Indonesian economy amidst the global crisis: good policy and good luck. ASEAN Economic Bulletin, 77-97.

Hill, H. (1999). The Indonesian Economy in Crisis. Singapore: Institute of Souteast Asian Studies Publishing

Hill, H. (2007). The Indonesian economy: growth, crisis and recovery. The Singapore Economic Review, 52(02), 137-166.

Hall, H. (2018). ASIA2067: The Indonesian economy: Southeast Asia’s giant [class handout]. College of Asia and the Pacific, Australian National University, ACT, Australia.

Patunru, A. A., & Rahardja, S. (2015). Trade protectionism in Indonesia: Bad times and bad policy.