International Monetary Fund
World Bank Group
|1998 Program of Seminars|
The magnitude of the problems arising from the volatility of capital flows and the depreciation of the exchange rates experienced by Indonesia cannot be over-emphasized. Capital outflow in the range of tens of billions of US Dollars in a matter of months and domestic currency depreciation from twenty four hundred to a US Dollar in July 1997 to fifteen thousand to a US Dollar in January 1998 undoubtedly put the economy in a massive shock. What is often not fully appreciated, in my view, is that exchange rate changes affect stocks rather than flows. A six-fold rise in the price of US Dollar in terms of domestic currency immediately increases the domestic currency equivalent of liabilities denominated in the US Dollar by six fold. Therefore, the impact of a sharp exchange rate change to corporates, financial institutions, and to the economy at large is more immediate and massive as compared to the impact of a sharp change in a variable that works through flows such as interest rate.
Such a massive change constitutes a great challenge for Indonesia. But, as in many other cases, challenges are often associated with opportunities. In a way, the great challenge we have been experiencing has created oppotunities to do many things. We have dismantled practically all monopolies our economy had been suffering from in the past, and a competition law (or an anti-monopoly law) is being formulated. We have renewed and strengthen our bankruptcy law to create a more level playing field for creditors vis-a-vis debtors. We have the opportunity to restructure, and to privatize our state-owned companies. We also have the need and opportunity to revise our Central Bank law to make the central bank more independent so as to enable it to exercise more effective monetary policy. In all, notwithstanding the problems and sufferings we have had to go through, we have taken advantage of the opportunities arising from the difficulties to improve our economic, social, political, and legal structures.
We still have challenges to face, and below are some of those.
Challenges 1. How to restore economic growth while ensuring that the new growth is of a better quality. While a speedy recovery is highly desirable, we have to avoid falling into the same trap in the future. As in the case of the challenges I described earlier, this is also an opportunity to improve our economic structure. A few examples:
- While we are fully aware of the importance of capital inflow in reactivating the economy, we have learnt a lesson that short-term capital inflow can be very volatile and destabilizing and therefore should be kept monitored and checked. There are no more predictable nominal exchange rates that will encourage unhedged external borrowing, but uncontrolled flows of short-term fund may recur as the situation stabilizes. Therefore, in the spirit of market-friendly policy, a prudential reporting system and external debt management are deemed necessary.
- While reactivation of the financial sector is important for the financing of economic recovery, improved prudential regulations have to be strictly implemented to avoid the same mistakes in the future. Besides, speeding up the process of bank and corporate restructuring while giving the same attention to structural reform will incur a huge cost to the public money, but they have to be done. Reactivating demand in a careful manner is therefore the main challenge in the future.
2. How to run economic stabilization and recovery program in a changing political and social structure. From the monetary policy standpoint, a massive capital outflow and a sharp currency depreciation would have to be confronted by a tight monetary policy. In a normal circumstances, the tight monetary policy, and its accompanying high interest rate, should not last too long; and after the currency is stabilize the monetary policy can be relaxed. But, in the changing political and social structure, the exchange rate may be disturbed the social unrests and political maneuvers. Thus, it may take longer to reach the exchange target, and the tight monetary policy should also last longer. This would put strains to economic recovery and create additional problems for bank restructuring efforts. However, a comprehensive economic recovery program, in which a tight monetary policy to attain a stronger exchange rate, remains a necessary condition for a successful recovery.
3. How to ensure that low-income groups are protected from crisis. It is clear that one year after the crisis began, recession has threatens to erode the remarkable achievement of the development in Indonesia during the last three decades. More than a hundred million of people who have been lifted out of poverty in the last two decades will be again exposed to hunger, and the massive lay-offs caused by recession has create a huge loss of human potential. A pro-poor fiscal policy is expansionary and therefore has to be accompanied by a consistently tight monetary policy. That means interest rate will unavoidably be high albeit temporarily, which - as elaborated earlier -- will increase the burden of negative spread to the banking system and raise the non-performing loans of the highly leveraged companies. Therefore, the challenge is how to help the poor without creating additional pressure on the structural and financial reform, so that inflationary and depreciation pressures can be subsided.
4. How to gain back the confidence of the international financial community. This is similarly important both for the Government and the private sector, particularly the domestic financial institutions that have suffered a great loss of confidence in the past one year. As far as the Government is concerned, this has to be achieved through consistent and credible domestic policies that will inspire investors confidence so that private capital inflow will start to resume. To the financial institutions, compliance with rules and regulations, better governance, and a very strict adherence to meeting external obligations in a timely manner are among the necessary ingredients.
With consitent and comprehensive policies as elaborated earlier, some notable progress has been achieved.
1. Exchange rate has strengthened during the past three months and starts to stabilize. The exchange rate currently stands at around 10,500 rupiah per US dollar, and I am confident that the rate will continue to improve to a level significantly below (i.e. stronger than) 10,000. Aside from the policies described earlier, the strengthening of the currency has been due to the following reasons:
- Reduction in the demand for dollars as a result of: (i) successful resolution of domestic banks' external debt and trade credit through the implementation of the 'Frankfurt Agreement'; (ii) although its implementation success remains to be seen, the agreement reached in Frankfurt on the resolution of corporate external debt has relaxed the pressure on exchange rate.
- Increase in the supply of dollar from Bank Indonesia who is acting as the fiscal agent of the Government.
- Continued strict adherance to a strong monetary policy discipline.
2. The recent success in resolving the problems of supply of basic needs has reduced the pressure on inflation. The rate of inflation can be expected to be much lower this month as compared to the rate in the previous months.
3. The stronger exchange rate and the lower inflationary expectation have made it possible to let interest rate decline somewhat. It is noteworthy, however, that the decline of the interest rate happened without having to relax the monetary aggregates.
4. The progress of Bank restructuring has so far been very encouraging, as the due diligence of the banks conducted by international auditors will soon be completed (end of October), bank recapitalization program was recently announced so that by end of the year a population of banks with 4% CAR will hopefully be materialized. Meanwhile, and amendment of the Banking Law has been submitted to the Parliament, which among others relax the limit on participation of foreign capital in the banking sector. The amendment is expected to be approved and enacted by the end of October.
5. In speeding up the corporate restructuring, government has taken an initiative to encourage out-of-court settlement between borrowers and lenders ('the Jakarta Initiative'). This is to complement the work of the Indonesian Debt Restructuring Agency (INDRA), which was established to implement the Frankfurt Agreement.
It is clear that there is sign of recovery, and we start to see the light at the end of the very rough tunnel. It is indeed still very challenging, and the daunting task is not yet over. However, as inflationary pressures start to subside and the exchange rate continues to strengthen, the real sector will have more room to maneuver and the financial sector may start resuming its normal intermediary function.