I\ J 8 8 I

The Asian Financial Crisis: V, :- a

,,
Indonesia and the Currency Board Proposal q--

In mid-February 1998, President Suharto of Indonesia contemplated a letter that he had just
received fiom Michel Camdessus, Managing D i t o r of the International Monetary Fund (IMF).
The letter said that the IMF would cut off support to the beleaguered economy if Suharto were to
introdu&\? currency board to stabiie the value of the Indonesian currency, the rupiah. The letter
represented a further escalation of the economic crisis that had begun on 2 July, 1997, when the
floatation of the Thai baht signalled an unprecedented financial crisis in East and Southeast Asia
and a reversal ik the decades of growth that had been achieved by many economies in the region.

Indonesia had been particularly hard hit by the crisis. Despite an Ih4F bailout plan, it had
suffered a collapse in its currency, runs on its banks, companies that could not pay their debts and
capital flight. Even worse was the violence that erupted in several parts of the country, loss in
confidence in the government and the spectre of social disintegration. On 4 February, however,
Steven Hanke, professor of economics h m Johns Hopkins University and an expert on currency
boards, proposed that Indonesia should set up a currency board system to stabilise the currency.
A currency board would fix the value of the rupiah to the US dollar, offering currency stability
while removing government discretion over monetary policy.

Suharto was highly receptive to the idea, but the international community did not share his
enthusiasm. As Suharto was-preparing to implement the currency board, a letter dated 11
February, 1998 arrived h m Michel Camdessus, outlining the Fund's opposition.

"In the present circumstances ... ifa ~t~~ency'board~roposalwere adopted, we

would not be able to recommend to the IMF Board the continuation of the
current programme because of the risks to the Indonesian economy .... This
wouId be a very unfortunate development, as it would shrink even firther the
reserve basisfor the currency board andfiather undermine its very slim chance
of success. lY

'
Blustein. Paul (1998). "Cunency DisputeThnaharp Indonesia's Bailoe Clinton Backs IMF in Pressing Suharto Not to Change
Cwnhy's M a & q Systemn in WarhinglmPost, Washington DC,14 Fcbnmry. 1998.

B e w Massar, Andrew Lee, Professor Mchael J. Enright and Dr. James Newton prepared this case for class
dismsion j v m public sources. ntis case is not intended to show effective or ineflective handling of decision or
buriness processes. I
lBis case is ptart of a p r o j e c t w e d by a teaching development grant$om the University Grants Committee (UGC)of
Hong Kong.
C o w & @ 2000 Ihe University of Hong Kong. No part of this publicafion may be reproduced or transmitted in any
-
form or by any'rneans electronic, mechanical,photocopying, recording, or otherwise (including the Internet) - without
the permission of The Universityof Hong Kong.
98/12C Version:22 June 2000
The letter put the question of whether to implement a currency board into sharp focus for Suharto:
should he follow the IMF's prescripts,and abandon the currency board plan? Or should he go
ahead with the currency board to try to stabilise the currency, and risk losing the support of the
IMF and the rest of the international financial establishment?

Indonesia before Suharb

Indonesia was a vast sprawling archipelago comprising over 17,000 islands spanning 5,000
kilometres across the equator, running from the west coast of Malaysia past the north coast of
Australia The islands of Sumatra, Kalimantan and Irian Jaya were the largest in the archipelago,
but were dwarfed in importance by Java, home to around 60 per cent of the country's population,
which totalled over 200 million, and the site of the nation's capital, Jakarta The principal ethnic
origin of 'the population was Malay, but there were approximately 300 different ethnic groups
spreading throughout the islands, which, with a matching number of languages and dialects, made
Indonesia one,of the most culturally diverse nations on earth. Ethnic Javanese constituted mund
45 per cent of the population, making them the dominant group, not only in t m s of numbers but
also in political power. There was a small ethnic Chinese community, totalling around three per
cent.

Java was the origin of several Hindu or Buddhist kingdoms that ruled parts of what was to
become Indonesia in its pr~colonialperiod. The island was also the seat of Dutch colonial power
from the arrival of the Dutch East Indies Company in the early 1600s, based at Batavia, which
was to become Jakarta. The fust stirrings of nationalist sentiment also emerged on Java in the
early twentieth century. A group of Dutch educated nationalists, led by Sukarno, founded the
Indonesian Nationalist Party (PNI) in 1927. The Dutch moved quickly to suppress the
movement, arresting the leadership and e x i l i i Sukarno to southern Sumatra.

However, the Second World War proved to be a turning:pointXinIndonesia's colonial history.

The Dutch surrender to the invading Japanese army 1942 destroyed the notion of the
invincibility of the colonial rulers. As the war in the Pacific drew to a close in 1945, the Dutch
attempted to reclaim their colonial territory. But Indbnesian nationalism had become a much
more coherent force. Just three days after the Japanese surrender, Sukarno and other nationalists
declared an independent "Republic of Indonesia" on 17 August, 1945. Four years of struggle
ensued before the Dutch ietreated. In 1949, the colo~alera ended and Sukarno took power.

Despite Sukarno's considerable personal charisma, his regime was characterised by political and
economic chaos. In part this was due to the economic dismay left over from the Japanese
occupation and in part it arose from the number and diversity of groups vying for power. The
Indonesian communist party (PKI), the nationalists, two organised Muslim groups and the
military all contested the political order. Major political change occurred in the mid-1960s. It
began with a failed coup attempt on 30 September, 1965, for which responsibility had never been
clearly established. The Communist Party was blamed by the military, led by Major General
Suharto. This appeared to act as a trigger, setting off a wave of mass killings that raged through
the remainder of 1965 and continued in the early part of 1966. The death,toll was iqpossible to
verifL and estimates range fiom under 100,000 to more than one million.

The violence, believed to have been oxhestmkd by the army, was directed at the communists,
real and suspected, their families and sympathisers. The CIA commented, "In terns of numbers

Adapted from Sdwam, Adam (1994). A Nation m Wuinng:IINibnesa in the 1990s Westview Press: Boulder
se/m 1 d and the Currency Bosrd Proposal

killed, the anti-PKI metssacres in Indonesia rank as one of the worst mass murders of the
twentieth century, along with the Soviet purges of the 1930s, the Nazi mass murders during the
Second World War and the Maoist bloodbath ofthe early 1 9 5 0 ~ Time . ~ magazine, on the other
hand, described the elimination of the communists as "The West's best news for years in Asia'*
The Communist Party, which previously listed a membership of two million, was eliminated as a
political force in Indonesia. This removed Sukarno's strongest pillar of support. Without the
backing of the Communist Party, Sukamo's position as leader became increasingly untenable and
the army's ambition to sit at the apex of political power grew. In 1968, Suharto replaced Sukarno
as President and declared the establishment of the 'Wew Order!'

The Suharln Era

i

im ewnomic legacy. The Sukamo govemment had expropriated all

The ~ e 4 , o r d e rinherited a d
foreign as&@ and had established sfate control over most markets, including foreign trade and
bank credit. \\?R economy was characterid by regulation and state controls. Exports were
stagnant, factofies were operating at a &tion of capacity and inflation was rampant. The
government was running a huge budget deficit, foreign debt was over US$2 billion and interest
on the debt was more than Indonesia's total export revenues. Economic disarray had contributed
to the instability of the Sukarno regime.
Economic Developments in the 1960s and 1970s
It became clear that reversing the economic situation and improving living standards would be
necessary for the New Order to establish its legitimacy. One of the first acts of the new regime
was to initiate a programme of economic reform. New policies included the encouragement of
forkign direct investment, principally in natural resource exploitation. The Suharto govemment
also reformed the banking sector in the mid-1960s, permitting the operation of both state and
private banks. In the early 1970s foreign exchange controls were abolished and the complex
structure of multipfe exchange rates was reformed. By 1971 the rupiah was fully convertible at a
fixed rate of 415 to the US dollar' and banks were free to offer foreign currency deposit accounts.

~ d o n e s i a ~major
s assets at that time, however, were in the primary sector. The three biggest
islands were rich in natural resources, including the second-largest tropical rainforest in the world
and extensive oil, gas and mineral reserves. Indonesian oil contributed significantly to economic
growth and provided capital for development. The sharp jump in oil prices in the first oil shock,
resulting in a windfall of US$42 billion in 1974, helped to fimd the development of physical
inhstructure as well as new industries such as steel, cement, chemicals and fertilisem6 As the
positive impact of the rise in oil prices declined, the rupiah was devalued by 34% in November
1978 to 625 to the US dollar to stimulate exports of non-oil products. This was accompanied by a
change in the exchange rate policy, whereby the rupiah was linked to basket of currencies instead
of only the US dollar7.Thanks to the second oil shock, in 1980181, the oil industry provided more
than 70 per cent of the state's income and contributed 82 per cent of export earnings. Between
1968 and 1981 GDP grew at an average rate of seven per cent per year, largely as a result of oil
revenues.
I
I

'ibid, p. 20
'ibid, p. 22 *
'EIU Counhy Profile: Indonesia 19%-97.(EIU, 19%: 18)
S c h m r ~ ~op
, cit, p. fl
' E l ~ o ~ d
WW: Indonerlaand the (Imwwy Baard Proposal

The 19809 and 1990s

The fitll in oil prices between 1982 end 1986 forced new changes. The rupiah was devalued by
28 per cent in 1983 and by a firrther 31 per cent in September 1986, when the exchange rate
reached 1,644 to the US dollar. Then h m 1988 the Government adopted a "crawling peg"
arrangement, allowing the rupiah to drift downwards by 3.5 per cent to 5.5 per cent per yea+ to
offset the impact of the inflation differential between Indonesia and its major trading partnersg

In late 1988, the Indonesian Government mounced fiuther major reforms. Politically protected
trading and distribution companies had stifled competition, leadiig to high prices and
manufacturing industries that could not compete in export markets. Key import monopolies were
dismantled to allow easier and cheaper imports of intermediate goods required for export
production Regulations on foreign investment were relaxed and simplified to attract new capital
and techn;qlogy. The government also lifted limitations on licences for private and foreign banks,
opening uphwhat had been a closely regulated industry. The number of private banks, many
owned by ethnic-Chinese, more than doubled to 135, and 18 new foreign banks were licensed.

Indonesia's economy grew at an annual real rate of 9.0 per cent in the 1980s and 7.9 per cent
from 1990to 1996. Per capita GDP surpassed US$1,000 for the first time in 1995, as compared to
the figure of USUO when Suharto took power. Total GDP reached US$227 billion in 19%, up
7.9 per cent from the prior year. Unemployment in 1996 was 4.5 per cent of a workforce of 85
million. The World Bank predicted that Indonesia would become the fifth largest economy in the
world by 2020. Services now comprised the largest sector of the economy, with manufacturing
second and primary production third [see Exhibits 2A and 2B].Mation was low; the currency
was stable; inflation was under control and government finances looked solid.
4

In contrast to other Association of Southeast Asian Nations (ASEAN) countries, Indonesia had
recorded a surplus on merchandise trade through the 1980s and 1990s [see Exhibit 51. In the
mid-1980s, oil and gas accounted for 70 per cent of total exports. But conscious development in
the nonsil and gas sectors progressively changed the picture. Manufactured exports grew from
less than US$l billion in 1980 to more than US$9 billion in 1990. By 1996, Indonesia's total
exports amounted to USM9.8 billion, 9.7 per cent higher than the previous year. Non-oil and gas
exports contributed 76.5 per cent of total exports, with textiles, footwear and forest products at
the top accounting for 37.7 per cent of all non-oil and gas exports. Oil and gas exports totalled
US$12.9 billion, half of which were destined for Japan. In the same year, imports totalled
USM2.9 billion with a 5.7 per cent growth over 1995. Japan was the leadiig destination for
Indonesia's exports in 1996, taking 25 per cent, followed by the United States (13.6 per cent) and
Singapore (9.2 per cent). Japan was the primary supplier of Indonesia's imports, contributing
19.8 per cent in 1996, followed by the United States (1 1.8 per cent) and Germany (7.0 per cent).1

According to the World Investment Report 1997, Indonesia was the third-largest foreign direct
investment (FDI) recipient in the Asia Pacific." From 1994 to 1996, approved FDI averaged over
US$31 billion per year. In the first half of 1997 alone, approved FDI in Indonesia tallied US$16
billion l2 Foreign debt, which had been increasing since 1988, reached more than 66 per cent of
1 ,
'ibid
Williamson J. (October 1998) "Crawling Bands or Monitoring Bands",I n t e r m r f d Finmix, Blackwell.
lo US Embassy. Jakarta, (1997), Indooresan Trade Through Mid-97- Z k GoodOldDqys?,URL:
h t t p : l h v w w . ~ ~ j ~ . o r g ~ e c o n l i n d m i d 9 7 . hJanuary
t m l , 1999.
l ' United Nations Conference on Trade and Development, (1997). WorIdlnvesbnen!Report 1997: TronmationalCoporatiionr,
~ k e t ~ f umdCompetitim
r e Policy, United Nations, Swiaaland, pp. 78.
l 2 Bank Indonesia, (1998), Approved Foreign Direct Investment Projecfs bySector; December 1998,
URL: http:llwww.bi.go.i~1ntVstatsmO603.rep, January 1999.
 WLZC 1ndonesb.and the Currency Board Roposal

GDP in 1991." Between 1988 and 1992, total foreign debt rose sharply to almost US$80 billion,
30 per cent of which was composed of private commercial loans. Overall, private capital inflows
more than covered the annual c w m t account deficit. Foreign banks had been keen to lend
because of the generally accepted bullish view of the country's growth. Indonesian companies
had bomwed in foreign currencies, mainly US dollars and Japanese yen because interest rates in
these currencies were low compared to rupiah rates. This could cut repayments by up to two-
thirds without exchange rate risk, as long as the Government maintained the fixed exchange rate
regime.

In its annual report for the year ended 30 April, 1997, the IMP4reviewed Indonesia's economy.
It noted that rapid expansion of credit to the private sector in 1995196 had resulted in an increase
in domestic demand and pressures on prices. Due to a decrease in the trade surplus, the current
account deficit widened from 1.6 per cent of GDP in 1994 to 3.2 per cent in 1995. While debt
levels remked high, the IMF recognised that the external debt burden had declined relative to
GDP and expsrts. Trade barriers had been coming down since May 1995 with the introduction of
across-the-board tariff reforms that were to be implemented in stages through 2003, bringing the
average tariff rate down from 195 per cent to 15 per cent. The report hailed the Indonesian
Government for reducing poverty, improving social indicators, reducing the economy's reliance
on oil and gas, and liberalising the economy.

However, the report regarded the continual excess demand and large capital inflows as important
policy challenges. The IMF recommended a surplus government budget to prepay external debt
and emphasised the importance of broadening the tax base. On the monetary side, it supported
the Government's measures to increase flexibility in exchange rate policy. To maintain rapid and
sustainable growth, the IMF believed substantial reform, especially in the financial and banking
sectors, was essential. In particular, it urged the Indonesian Government to resolve the problem
of insolvent banks and to recover non-performing loans in order to reduce the vulnerability of the
ecooomy to shocks and to lessen any moral hazard. The report also recommended liuther
- deregulation and opening of the economy and emphasised the need for greater transparency in
policy implementation. Despite these recommendations, however, the overall tone was generally
positive.
Family and Friends of Suharto
Transparency had long &en an issue in Indonesia. Political and family connections had become
the focus of considerable criticism. Estimates of the Suharto family fortunes by Western
observefs ranged from US$16 billion to US30 billion, much of it under the control of Suharto's
six children. Critics had suggested that partnemhip with one of the Suharto children was an
essential prerequisite for winning major contracts from the Indonesian government. Many
multinational companies operating in Indonesia, including AT&T, General Electric, Hopewell
and Siemens, used companies controlled by the Suharto children as agents or joint venture
partners. Members of the Suharto family often were given shares in foreign ventures in
Indonesia, h m which they collected substantial dividends, without paying for them.15

Suharto granted his cqldren and business associates licences, monopolies or government
contracts through piesidential decree. One decree exempted the sole importer of certain

l3 World Bank .
' International Monetary Fund, (1997), AlnualRepot? of the Executive Boardfor the Financial YemEnded April 34 1997,
Washington D.C.. pp. 80-81.
'' Waldman, P., Brauchli. M. W. and Solomon, J.. (1999), "Suharto Family Missed Out On a Forlure?' In 77w h i m WallSlreet
Jouml, 4 January, 1999,pp. I & 7.
 98/12C Indonesia and the (Inrency Board Pmposal

automobiles from import duty. Not surprisingly, that importer was owned by one of his sons and
a son-in-law. Since 1981, there had been 19 such decrees that directly benefited companies
owned by Suharto's children or business associates. In addition, Suharto's yayasans, or
"presidential foundations fimded by voluntary contributions for charity," collected levies on
numerous items ranging h m utility bills to movie tickets. Although the foundations had done
some good works such as building schools, they also reportedly bought votes for Suharto's
political party and served as Suharto's personal banks for projects that enriched his children or
associates.

The family's wide range of business interests was often l i e d with the interests of close Friends
of the President. Suharto's eldest daughter, Siti Hardijanti Rukrnana (known as Tutut) had
interests in such fields as telecommunications, infkastructure development and banks. She and
her brothq Sigit owned 32 per cent of Bank Central Asia, one of Indonesia's largest private
banks. Thh, bank was controlled by Suharto's close friend, 83-yearsld billionaire Liem Sioe
Liong, who had known Suharto since the 1950%and whose rise to prominence had begun as an
important supplier to the army under the patronage of the then Colonel Suharto. Liem's main
vehicle, the Salim Group was Indonesia's largest private company. The firm, which had interests
in dozens of industries, including control of Indonesia's major cement and steel companies and
Bogasari Flour Mills, one of the world's largest commercial buyers of wheat,16 reportedly
accounted for some five per cent of Indonesia's GDP.

Tommy Suharto, the youngest Suharto child, dominated the national clove monopoly which had
had to be rescued by the government in 1990 at a cost of US350 million. He was also chairman
of the Humpuss group, which had interests in shipping, petrochemicals, wood manufacturing,
s u m and palrndil plantations. Tommy's most publicised - and criticised - concession was for
the development of the national car, the T i o r . The aim was to produce a car with 100 per cent
. local content and, as a result, the car was exempt fiom Indonesia's punitive luxury taxes and
tariffs, even though initially it was assembled from imported "knocked down" kits. He and Bob
Hasan, another close friend and golfing partner of Suharto, jointly owned the domestic airline,
Sempati Air. Hasan, an ethnic Chinese named The Kian Seng, was also chairman of the
Indonesian Wood Panel Society epkindo), the Kalimanis Group (one of the world's largest
plywood exporters) and PT Astra, the nation's largest automobile company. He also ran PT
Nusantara Ampera B h a . a holding company for President Suharto's own investment interests.

Suharto's second-oldest son, Bambang, formed the conglomerate Bimantara, Indonesia's largest
pribumi (Muslim owned) conglomerate. Bimantara was first given a monopoly in the plastics
industry, and later diversified into e l w c s , shipping, telecoms, ~ t r u c t u r eagriculture
, and
most other ateas of the Indonesian economy. Bambang had had as investors or joint venture
partners major companies such as Deutsche Telekom, Siemens, Hyatt and Hyundai. Bambang,
TWut and their uncle, Sudwikatmono, were also major shareholders in the S a l i Group.

The Asian Financial Crisis

The Asian crisis was generally dated iiom the f l d o n of the Thai baht on 2 July, 1997. The
pressure had been building on Thailand since February, but the government had remained
resolute in its defence of the currency. On 18 June, Thai Psime Minister Chavalit Yongchaiyudh
declared, "We will never devalue the baht."" Yielding to the rising current account deficit and

l6 SC~WBIZ,
Adam, (1994). A Ndm in Waiting.
" Financial Tima 12 Jan 1998
I
w= Indoneriah d nd Currency Board Pmposal

the dwindling foreign reserves, the Thai government finally floated the baht on 2 July, ending
almost 25 years of tying the currency to the US dollar.18 The exchange rate dropped sharply from
25 to 30 baht to the US dollar, triggering the so-called "contagion" that spread throughout the
region. Thailand's closest neighborn were hit first. In mid-July, Malaysia abandoned its
defence of the ringgit and the Singapore dollar depreciated to its lowest level since 1995.

Initially Indonesia took precautionary measures to defend the rupiah. Since the mid-1990s the
exchange rate had been allowed to fluctuate around its parity, thus substituting a "crawling band"
for the previous "crawling peg". This band had gradually been widened and, by mid-1997, was
set at +I- 4 per cent. On 11 July the central bank announced that it,was widening the band to +I- 6
per centI9 to increase the risks faced by currency ~peculators.~~ The Minister of Finance, Mar'ie
Mohamhed, was reported as saying that the President had ode@ him to keep the rupiah stable
and that &era11 exchange rate policy would remain unchanged. The central bank also entered the
foreign exchange market, reportedly spending US$l billion defending the currency between 21
July and 29, rhughly 5 per cent of its total foreign exchange reserves.

Despite these measures the c m n c y continued to decline. On 14 August the defence was
abandoned and the rupiah was floated. In two days it fell to 2,755 to the US dollar, a drop of 15
per cent. Suharto created a high-level crisis management team to shore up confidence in the
rupiah and the economy. Members included Finance Minister Mar'ie Muhammed, Governor of
the Central Bank Sudradjad Djiwandono, State Secretary Moerdiono, presidential advisers
Widjoyo Nitusan, and Ali Wardhana, and Coordination Minister for Economic and Financial
affairs Saleh Afiff. In August, overnight interest rates were raised dramatically to help protect the
cyrency [see Exhibit 81. However this put intense pressure on companies carrying local debt.
On 3 September Suharto announced economic reforms designed to restore confidence.
Government expenditures were to be reduced in the light of an expected decline in tax revenues
to minimise fiscal deficits and current account difficulties. Large-scale projects with a high
import content, both public and private, were to be postponed. Sales taxes on luxury items were
raised and tariffs on intermediate goods were reduced to stimulate exports. In addition, the
domestic banking sector was to be reformed by merging or liquidating troubled banks.

Whilst the exchange rate recovered slightly when the reforms were announced, it and the stock
market soon both began to slide. Finance and bank shares, in particular, dropped on investor
concerns about exposure to the foreign exchange markets and to foreign debt. Many Indonesian
companies and financial institutions had borrowed in foreign currencies, and had benefited from
the differential between higher rupiah interest rates and lower foreign rates. Most of these loans
had been obtained without hedging the currency risk, as many believed the pegged exchange rate
would protect them from foreign exchange risk. As much of half the total debt was in short-term
loans, which would soon be due for repayment. However, the lower exchange rate made
repayments and ongoing interest payments much more expensive in local currency terms.
Concern was growing that foreign debt was not so much a mountain as an iceberg. Estimates of
total private foreign debt in Indonesia were initially in the order of US$65 billion. However,
private debt was poorly reported and there was a growing fear that the real figure could be US$20
billi~nto US$SO billion higher.

When the Asian crisis first hit, the view of the international investment community on Indonesia
had been largely positive, echoing the World Bank's praise of Indonesia's policies in its June

''Bangkok Bank Monthly Review, June 1988

l9 Williamson, op cit
20 Bloomberg WEFA report "Effectof Rupiah Float" 2 September 1997
9e/M Indmsta and the C u n w y Board Proposal

1997 Annual Repart. There was a perception that the stability of the Suharto regime would
mitigate political and exchange rate risks. Even after the rupiah was floated in mid-August,
international brokerage firms had continued to issue bullish reports on Indonesia. They argued
that the economy was fundamentally sound, despite the current account deficit of USs7.8 billion.
The argument was that this represented less than four per cent of the country's GDP,whereas
Thailand's deficit had been almost eight per cent in July. As the actual dimensions of the debt
problem began to emerge, international confidence waned. International observers had begun to
place the blame for the Asian crisis on "crony" capitalism, the handing out of economic rewards
to the politically connected. Indonesia was seen as a prime exponent of "cronyism." The
currency started to sink rather than float. On 6 October the rupiah fell to a new low of 3,845 to
the US dollar.
\
These evbts triggered a U-turn in government policy. On 8 October, 1997, with the pia ah down
60 per ceni from its pre-floatation value of 2,400 to the US dollar, the local banking system on the
verge of collapse and Indonesian companies defaulting on their loans, Suharto appealed to the
International Monetary Fund (MF). The initial intention was to confine institutional assistance
solely to policy advice and hence avoid the consequences of an IMF loan. However, on 31
October the IMF announced a loan package of US$23 billion assembled from various sources
including the IMF, the World Bank and the Asian Development Bank, making it the biggest
rescue package since the Mexico bailout in 1994. Under IMF rules, the loan was conditional on
economic reforms, which focused on four main areas.

First, restructuring was to be carried out in the financial sector wih measures including closing
non-viable institutions, merging state banks and establishing a timetable for dealing with
remaining weak institutions, and improving the institutional, legal and regulatory framework for
the financial system. Second, structural reforms were to be implemented to enhance economic
efficiency aod transparency, including liberalisation of foreign trade and investment, dismantling
of domestic monopolies and expanding the privatisation programme. Third, the rupiah was to be
s t a b i l i i by retaining a tight monetary policy and a flexible exchange rate policy. Fourth, fiscal
tightening equivalent to about one per cent of GDP in 1997198 and two per cent in 1998199 were
tb be undertaken to yield a public sector surplus of one per cent of GDP in both periods, to
facilitate external adjustment and provide resources to pay for financial restructuring. These
measures included cutting low-priority expenditures, eliminating value-added tax exemptions and
adjusting administered prices, including those on electricity and petroleum products.

Finance Minister Mar'ie Muhammed and Bank Indonesia Governor Sudradjad Djiwandono
immediately announ4 the liquidation of 16 troubled banks. They said the banks were
"insolvent to the point of endangering business continuity, disturbiig the overall banking system
and hanning the interests of s~ciety.'~' Most of the 240 private Indonesian banks were
considered to be heavily undercapitalised and had been since the banking deregulation measures
of 1988. With the rupiah's fall, banks were under even more pressure due to foreign exchange
losses, deteriorating assets and a loss of depositor confidence. Originally 19 banks were to have
been targeted, but political manoeuvring reduced the number to 16 before the order was
confirmed by the President. Surprise was expressed when it became clear that the list included
Bank Andromeda, as this was owned in part by Suharto's second son, E3mbang Trihatmodjo.
Observers were puzzled by the Bank Andromeda closure, especially given the exemptions of
Tommy's national w and middle daughter Sitis Hedijanti Herijadi's project to build the world's
W1X: Indonesia aid the tummy Board Roposal

longest bridge in September. In the case of Bank Andromeda, the hypothesis emerged that
Suharto had paid little attention to the details of the order and, hence, unwittingly closed a part of
the family's business interests. In a few weeks, however, Bambang reopened the closed branches
under a new name and with a new banking licence.

Even after IMF's intervention, the rupiah had continued its downward spiral [see Exhibit 91. The
bank closures as ordered by the IMF had caused depositors to take some US$2 billion out of local
banks, which they feared would be the next ones ordered closed, and deposited it in banks they
considered safer. By November 1997, two-thirds of the country's banks had experienced m.
1998
Other &q the bank closures, for the first few months the Indonesian government implemented
few of the'@W mandated reforms. Even as additional support swelled the IMF bailout package
to US$43 billion by January 1998, tensions between Indonesia and the IMF increased. On 6
January, ~ u h & presented the 1998 budget - one that the international community looked to as a
test of Suharto's seriousness about reforms. The budget breached the IMF conditions, and
Indonesia's pledges, by failing to end subsidies, failing to end monopolies, failing to run a surplus
and failing to use assumptions that the international investment community thought realistic.22
The Indonesian Government claimed that riots had erupted in several East Java towns because of
anger over rising food prices and that further price increases and cuts in Government subsidies in
food and gasoline prices, as called for by the IMF programme, would lead to more severe social
unrest. Confidence in the international investment community collapsed, sending the rupiah to
10,000 to the US dollar on 8 January.

United States President Clinton personally telephoned Suharto to ask him to abide by the pledges
he made to the IMF in October. American concerns were not confined to economic conditions
but included fears about domestic security. The risk of social unrest in the world's largest
Muslim nation and Asia's largest oil exporter was not being taken lightly by Washington. Prime
Minister Hashimoto of Japan also called Suharto, urging him to follow the IMF reforms. Suharto
assured him that the Indonesian government was# making the ''utmost efforts" to restore
confidence and that the IMF reforms would be filly implemented. The IMF dispatched its
Deputy Managing Director, Stanley Fischer, to Jakarta to speak directly with Suharto. Fischer
had been quoted as saying that the IMF programme "can't go ahead if the Indonesian government
isn't supporting the measures that it said it ~ o u l d . " ~

Fischer emerged from the meeting saying that Suharto "didn't leave any doubt that he was willing
to get behiid the programme and go beyond what had been agreed to in the original
programme."24 The issue appeared to have been resolved. Two days later, IMF Managing
D i t o r Michel Camdessus referred to a "strengthened and reinforced economic programme"
and said that he expected inflation to remain below 20 per cent and the current account deficit to
change to "a sizeable surplus." To achieve this, a raft of revised reforms was announced. The
1998199 budget would operate with a one per cent deficit instead of a one per cent surplus, fie1
and energy subsidies would be rapidly phased out and twelve major infkistructure projects would
immediately be cancelled. The National Logistics Board, Bulog, was t o lose its monopoly on
domestic distribution of sugar and wheat, while retaining its monopoly on rice. The special tax
and credit privileges granted for Tommy Suharto's nationdl car project were also to be revoked. I
22 For example, the budget had been calculated using an exchange rate assumption of 4,000 (JF Nuantam, 7 Jan - daily comment)
Bloomberg I l January,1998
Bloomberg 12 January, 1998
981X Indonesiaajd the Currency Board Roposal

Appearing live on television on January 15, President Suharto signed a 50-point letter of intent
outlining the measures. He also added that the budget would use an assumed exchange rate of
5,000 rupiah to one US dollar in the calculations rather than the previous rate of 4,000. He would
also appoint a council of economic ministers reporting directly to him to oversee the
implementation of the programme. The initial reaction in financial markets was positive, with the
rupiah recovering to 8,100 shortly after Fischer's visit. However the recovery did not last as
concerns about tight liquidity in the banking system and failure to spell out necessary bank
reforms remained. There was also a feeling that the problem of private debt had not been directly
addressed and a worry that the reforms were too much for the Suharto government to handle.

On 18 January, 11998, at the age of 76, President Suharto announced that he would stand for a
seventh five-year term as President He chose Research and Technology Minister B. J. Habibie
as his Vi'-Presidential candidate. Concerns immediately rose that Habibie's ardour for
expensive high-tech projects would clash with IMF calls for austerity and international
confidence plunged again. By 23 January the rupiah had fallen to 16,500 to the US dollar. As
part of the IMF 'plan, Government subsidies began to be removed from staple items. Prices hikes
for staple items such as food, cooking oil and kerosene caused riots in Java cities.

Panic rapidly spread to the islands of Flores, Sumbawa and Sulawesi. Chinese shopkeepers were
often the targets of the mobs, heightening fears of a racial purge and stirring memories of the
mass killings of the 1960s. Capital flight accelerated, with much of the billions of dollars
estimated to have left Indonesia by the end of January attributed to Chinese businessmen.
Indonesia's economy and social structure were crumbling. Gasoline prices were scheduled to rise
in two months, raising fears of further riots. With daily disturbances and troops on the street, the
SuhWo government was under great pressure to do something quickly. Leaders of the Muslim
parties and other opposition leaders began to call for Suharto to stand down.

The Cumncy Board

On Monday, 4 February, help appeared to be at hand. Steven Hanke, an economics professor at
JO& Hopkins University in the USA and a "self-styled trouble-shooter", had a 90-minute
meeting with President Suharto in which he proposed that Indonesia adopt a currency board.
Hanke had successfully advised Argentina, Estonia and Lithuania on establishing currency boards
that had linked their currencies to the US dollar. The closest example of such a system in Asia
was found in Hong Kong, where the local currency had been linked to the US dollar at a rate of
W 7 . 8 to US$l since 1983. Hanke was named a special economic adviser to the government,
recommending that Indonesia should establish a currency board "as fast as you possibly can.'m

The currency board Hanke proposed for Indonesia was a strictly orthodox currency board in
which the local currency would be set at a fuced exchange rate to an anchor currency. The board
was to maintain full convertibility between the local currency and the anchor currency. Market
forces would then determine the money supply of the local currency. If rupiah holders switched
to US dollars, the rupiah money supply would contract and rupiah interest rates would rise. If
holders of US doll& were tempted by high rupiah interest rates to buy rupiah, local interest rates
would fall. Thus, both the local money supply and interest rates would be set by market forces.
Hanke contended that the currency board should be completely transparent and that members of
the board should have no discretion in setting money supply or interest rates.

Asian Wall Sheet Journal, February 1998

 If the currency board system successfully stabilised the rupiah at a favourable rate, many
companies and banks with debts in foreign currency would be able to pay off their debt and
become solvent again. The key then was to fix the rupiah at a rate that would allow more private
debts to be serviced, could be covered by the level of foreign reserves and could withstand further
speculative attacks. Hanke once indicated Rp5,000 to US$l was a~propriate.~~ The foreign _
exchange market was looking at 5,500, while others believed 7,000-8,000 would be more
realistic. In the second week of February, the rupiah bounced back fiom Rp9,000=US$l to
between Rp7,400 and Rp7,600. The official foreign reserves stood at US$17 billion. According
to the Bank of Indonesia, MO totalled Rp37.5 trillion, M1 Rp92.8 trillion and M2 Rp450.7 trillion
in January 1998.27
Within Indonesia there was concern as to whether the government had the political will to accept
the highL@rest rates that could follow. A serious outflow of capital could trigger automatic
increases qinterest rates to levels (some thought 200 per cent was not impossible) that could lead
to widespread bankruptcies and job losses. If this in turn led to a reversal of policy and the
currency boardwas disbanded, this could lead to further economic and social disruptions. Others
feared that the currency board would be used to artificially prop up the value of the rupiah until
the ruling family's business interests could be sorted out, foreign debts hedged and money could
be sent out of the country at a favourable exchange rate. Then, they feared the currency board
could collapse bringing even greater difficulties.

On 9 February, Suharto announced that the government intended to adopt the currency board
proposal and hence to fix the exchange rate of the rupiah. The proposed currency board was
hailed by Suharto's inner circle as well as many Indonesians who felt that this was the only way
to Tstore confidence in the depreciating rupiah. The hope was that currency stabilisation would
assist firms to repay their foreign debts, help the country in importing critical foods and materials
. and get the private sector moving again. The international community and many research
analysts, on the other hand, believed that the currency board would not only fail, but would lead
to fiuther economic hardships. A World Bank spokesman said, "This is not something we
recommend at this time." US Treasury Secretary Robert Rubin also professed his hesitancy: "I
thi& there are a lot of issues that need to be worked through before you get to the question of
whether or not you should have a currency board.'nB The international press dubbed the idea a
"quick fix" and a threat to the policies of the IMF and other international institutions. However,
the IMPS Michel Camdessus took a circumspect route, suggesting that the January agreement
would be sufficient to restore economic stability. The general tone of the IMF's initial position
was that reforms should take place first and then a currency board could be considered.

Hanke also came under attack for having gone against the international establishment. He
replied, "I know what I'm doing," he said.29 "I know what causes currencies to blow out and
what causes a currency crisis. And I also know what fixes the crisis." Despite the international
and domestic criticisms, the government initiated legislation to allow for the establishment of a
currency board. On 13 February, following his second personal meeting with Suharto, Hanke
announced the President's agreement with the plan. He went on to inform the press that there
w p nothing to stand in the way of immediate implementation of the currency board.

26 Vasuki, S. N., (1998), "Jakarta to press ahead with cunency boardn In B~tsinessrimes, Singapore, 14 February 1998, pp. 1.5.
MO, MI and M2 are all measures o f the money supply. The major component of MO is notes and coins held by the public. Mi
includes MO togetha with demand deposits (ie checking accounts). M2 includes M1 and time deposits.
"W a s h i i n Post,12 February 1998
29 washington Post,12February, 1998
se/Z 1 d and the CurreKy Board Ploposl -

At this point, the IMF changed its previous stance. Carndessus made a public statement opposing
the imposition of a currency board in Indonesia, demanding that the agreed reforms take place
first, "We are of the strong view that this moment has not yet come in Indonesia. The failure of a
currency board would completely undermine credibility and policymaking, and seriously damage
the country's growth prospects.'* His 11 February letter to Suharto warned that the IMF would
withdraw its support for what had become a US$43 billion aid package if the currency board were
implemented. On 13 February, US President Clinton called Suharto to urge him to drop the
currency board plan.

Dilemmas
President Suharto was faced with one of the toughest dilemmas of his 32-year rule. Should he
push ah& with the IMF refonn programme, austerity, painful social dislocation and possible
unrest coukl result. The currency board seemed to offer a ray of hope that the currency could be
stabilised and ,then the economy might be set working again in less turbulent conditions. On the
other hand, shohld Suharto defj international opinion he would lose the support - and money - of
the IMF, and perhaps the ability to implement the currency board in the first place.

The IMF also faced a dilemma The Financial Times summed it up, "In proposing to introduce a
currency board without the Fund's consent...b donesia] has put the IMF in a position where its
ability to treat with all but the smallest and weakest countries would be placed in question.. ..'"I

There was no shortage of critics of the IMF. Professor Jeffery Sachs, director of the Harvard
Institute for International Development, claimed that the IMF had mistaken a financial panic
caused by short-term debt for deep failures of macroeconomic and financial policies?* He
claimed that the IMF had imposed macroeconomic contraction on top of the market panic,
worsening the situation by "creating much more panic than calm."33 Sachs also pointed out that
the IMF provided no substantive documentation of its decisions except for a few pages in press *

releases, commenting "it pays lip service to 'transparen~y."~Professor Raffer of the University :
of Vienna said that the IMF was "not only totally exempt Erom any financial accountability for
what it does, but even allowed to gain from its own niistakes or sloppy work"35 Some argued
that many companies and financial institutions could have been saved had the IMF dealt with the
foreign debt problem immediately.M Former US Secretary of State Dr. Henry Kissinger criticised
the IMF programme as having "crippling effects" on economies it intended to cure?'

Harvard Professor and a former Chaiian of the US President's Council of Economic Advisors,
Martin Feldstein, questioned the whole approach to structural reform:

"The Z M F would be more gective in its actions and more legitimate in the eyes
of emerging-market countries if it pursued the less ambitim goal of maintaining
countries ' access to floatable capital markets and international bank lending.... i
The IMF should eschew the temptation to use currency crises as an opportunity

'O Financial Tunes 14 February, 1998

" Financial Times 17 February. 1998
'' Sachs,JetEey, (1997). "Power unto itself'ln Fimmziial Times, 11 December, 11997, pp. 21.
'' Kaur,Hardev. (1998), "From economiccrisis to political unrest the IMF way" In Bwi- 2'Ime.q 17 February 1998, pp. 4
''Sachs, J e w ; (1997). "Power unto itself",p. 21.
" Raffer, Kunibert, (19971 "Make IMF share the riskwIn Financial Times,22 December,1997, pp. 14.
l6 Tan,Augustine H. H., (1998), "Currency Board aQuick FixwIn The Swd! Times, 14 February 1998, pp. 54.
" Kaur, Hardev, (1998). "From economic cnsis to political unrest the IMF way".
 ,.
98/lX Indonerb and thc Currency Board Proposal

8
DCHIBrF 1
MAP OF INDONESIA

I
Source: Perry-Castafieda Library Map Cellection, .The University of Texas at Austin.
 EXHIBrr 3A
BAIANCEOF PAYMENTS OFINDONESIA
' (in million US dollars at end 3 1 December)

I I
1 GDP of Indonesia at current
/
I
price in million US$*
'
72,482 87,337 75,932 114,427 128,170 139,118 158,007 202,132 227,397 214,593

I dote: * denotes figures'derived h m GDP data from Asian Development Bank and exchange rates data h m the International Monetary Fund.
jl/
I ,

Source: Asian Development Bank, (1998),Country Data -Indonesia, URL: http://internotes.asiandevbank.0rg/notes/dom98/ino98dwn.xls, December 1998.
 /

WX lndonsla and the Currency Board Proposal

4 EXHIBII 3B
BALANCE OF PAYMENTS OF THAIlAND
(in million US dollars at end 3 1 December)

I Other eoods services and I I I I I I I I I I I

GDP of Thailand at current

/ prices in million US$*

' I
Note: * denotes figures derived from GDP data from Asian Development Bank and exchange rates data from the International Monetary Fund.
Source: Compiled from Asian Development Bank, (1998), Country Data - Tirailand, URL: bttp:/lintemotes.asiandevban~noteddown98ltha98d~.xls,
January
1 1999.
I

'
I
1 -
 EXHIBIT 4
GO-RNMENT BUDGR OF INDONESIA
(at current market prices in billion rupiah)

-
I source: Asian Development Bank,(1998), Country Data Indonesia, URL: http://internotes.asiandevbankorg/notes/down98~no98dwn.xls,December 1998.
I
I

1 '
 a m a s
MmRTS AND IMPORTSOF INDONEHA BY SIX SECHONS
(in million US dollars)

II
I

Total Trade Balance I 13,116 1 8,327 1 4,766 1 5,971 1 5,799 1 3,838 1 3,272 1 6,687 1 8,495 1 8,070 1 4,789 1 6,886 1 11,772

-
Source: Asian Development Bank, (1998),County Data Indonesia, URL: bttp:Ninternotes.asiandevbankorglnotesldno98dwn.x~, December 1998.
 1980 1985 1987 1988 1989 1990 1991 1992 1993,c- 1994 1995 1996 1997
Money Supply (MO) in biiion
rupiah' 2,153 4,440 5,782 6,246 7,426 9,094 9,346 11,478 ,,94,431 18,634 20,807 22,487 28,424
Money Supply (MI) in billion . .
rupiah' 4,995 10,104 12,685 14,392 20,*114 23,819 26,341 28.779 36,805 45,374 52,677 64,089 78,343
Money Supply (M2) in billion
rupiaha 7,691 23,153 33,84 41,998 5e704 84.630 99,058 119,053 145,202 174,512 222,638 288,631 355,643
Exchange Rate (versus USSl Ib 627 1,111 1,644 1,686 1,770 1.843 1,950 2,030 2,087 2,161 2,249 2,342 2,909
Interest Rate (InterbanlQb 14.47% 15.00% 12.36% 13.90% 14.91% 11.95% 8.60% 11.62% 15.23% 14.14% 28.32%
US Fed Funds RateD 1 13.36%1 8.10%1 6.66%1 7.57%1 9.22%1 8.10%1 5.69%[ 3.52%1 3.02%1 4.20%1 5.8411 5.30%1 5.46%
I
I -
Source: Compiled from Asian Development Bank, (1998), Corrnhy Data Indomesia and Key indicators of deveIoping Asian andPacific countries 1997; Bank
I Indonesia, (1998), FinancialStafistics; and Attrasoft, URL: http://www.attrasoft.com.
I

EXHIBIT8
MONETARY INDICATORS OF INDONESIA: MARCH 1997 TO JANUARY 1998

Source: Compiled from Datastream, December 1998; and Bank Indonesia, Money Supply andZts Affecting Factors; and Attrasoft, URL: http://www.attrasoft.com.
' Note: a figures at end of period
averages over the period
 MHIBrr9
TRENDS OF SELECED ECONOMIC IND~CATORSOF INDONESIA: 1JANUARY,l997 TO 11FEBRUARY, 1998

I
I . .
I i
; I
.I i!

Source_:Datastream, January 1999.

between the text and this graph are due to differences in data sources.
Note: ~iscre~ancies
 APPENDIX I
ADJUSTMENT PROGRAMMES OF THE INTERNATIONAL MONETARY FUND

The IMF was set up to offer financial assistance to its members when those countries were
facing balance of payments problems. If the problems were not too severe, the Fund offered
short-term loans that were repayable within five years. Longer-term and more substantial
lending was also available, but would in every case be subject to structural policy reforms in
the borrowing country. This was known as IMF 'bnditionality". The objective was to
address the root causes of the problem so that the borrower could generate the capacity to
remedy the payments imbalances and could also repay the Fund's loans.

The conditions formed the basis for the adjustment programmes that the IMF required the
borrowers to follow. Although they differed somewhat from case to case, generally these
inclged the following.
i
1. ',A reduction of government spending and an increase in taxation. This was intended
to\reduce domestic demand and hence to curb the country's imports.
'.
2. The elimination of government subsidies, often on basic items such as he1 and food.
This would contribute to the reduction in government expenditures and also leave the
allocation and pricing of goods and services to market forces. The underlying
rationale was that free markets allocate productive resources more efficiently than
systems involving government intervention. For this reason, the IMF also required
the removal of regulatory controls over domestic industries. '

3. The reduction of extemaI trade restrictions such as tariffs and quotas together with a
reduction in foreign exchange restrictions. Again, the objective was to free markets
from government intervention

4. The achievement of a realistic exchange rate. In cases where the rate had become
overvalued, hence leading to an increase in imports and a reduction in exports, a
devaluation or depreciation of the currency was required. This was intended to
+ improve international competitiveness and to reduce imports.39

5. An increase in domestic interest rates. This also contributed to a reduction in

domestic demand and hence a reduction of imports.40
d

The borrowers undertook to make specific policy changes, depending on their particular
c w c e s , and provide the IMF with targets for a number of economic benchmarks.
These included growth of bank credit, limits to government budget deficits or their
elimination, and levels of external borrowing. The targets were used by the Fund as criteria to
assess the performance of borrowing countries as reforms proceeded. This was then taken
into account when releasing progressive trenches of the loans, thus allowing the Fund to
monitor and influence the policies of the borrower^.^'

39 Khambata D.& Ajami R (1992), ''International Business, Theory and Practice". Macmillan
'O W a l m R S. & Blake D.H. (1992) '"The Politics of Global Economic Relations". F'rentice Hall
4' Khambataop.cit.
 APPENDIX n
EXCHANGE RATE ARRANGEMENTS

From 1945 to 1998, there had been two d i c t l y different exchange rate systems operating in
the global economy. Under the 'l3retton Woods" system, the major trading countries of the
Western world fixed the exchange rates of their currencies to the US dollar, which in turn was
fixed to gold at a specific price. This system began to break down in the late 1960s and
collapsed in 1973 when the lynchpin cwency, the US dollar, was taken out of the fvred rate
system and allowed to float. From that point, exchange rates were no longer determined
principally by govenunents but by the operations of the foreign exchange markets.42 As of
1998, the following currency regimes could be found:
Floating Rates
If gqvernments make no effort to manipulate the exchange rate but leave its determination
entidy to market forces, a 'Purefroating" system is in place. Most governments attempt to
influence the price of their currency on the foreign exchange markets. The most common
method iQy means of intervention in the market, when government agencies buy or sell their
own curretky. Some governments do this intermittently; others do so regularly. Whatever
the frequency, this system is known as a a'managedJoat" or alternatively as a "dirtyfloat ".
Pegged or Fixed Rates
A tighter method of control occurs when a country fixes, or "pegs", its exchange rate to
another currency, generally that of one of its major trading partners. Under this arrangement,
the home currency floats against all other currencies along with the fluctuations of the chosen
peg currency. The US dollar has been one of the most popular choices for a peg, especially in
Asia, and the French h c has been popular particularly amongst France's former colonies.
Often the currency is allowed to fluctuate by a predetermined amount or "band" around the
pegged exchange rate before the government intervenes in the foreign exchange market.

Under a "crawling peg" arraugement, the government allows small periodic changes in the
pegged rate, permitting the exchange rate to shift gradually over time. Generally, the changes
lead to a gradual depreciation rather than an appreciation of the pegged currency. As an
" alternative to pegging to a single currency, a count^$ may fix its exchange rate to a "basket of
currencies", a weighted average of diierent currencies, with the individual weights usually
selected to reflect the relative importance of each to the country's trade.43
.+
Under a "currency board", a note-issuing authority, the "board", guarantees to buy and sell
domestic currency notes at a fixed exchange rate against a chosen foreign currency (the
anchor currency) without limit, thus ensuring complete convertibility of domestic notes into
the notes of the anchor currency. This requires the board to hold reserves of the anchor
currency equal to at least 100 per cent of the domestic currency issued (MO) - at the fixed
exchange rate (i.e. the domestic currency is fully backed by foreign reserves). This
requirement distinguishes an orthodox currency board from a central bank which can print
money at will. Hence the money supply and interest rates adjust automatically, removed from
the government's control. If the public wishes to exchange local currency for the anchor
currency, the supply of domestic currency will decrease and domestic interest rates (Pe price
of money) will rise. Eventually the rates will become sufficiently attractive for the public to
switch back into local currency and the rates will begin to fall. The interest rates of the
anchor currency are set by the system in place in that currency's national jurisdiction. 44

42 Hill C.W.L.(1998). "Global Business Todayw.McGraw Hill.

" Khambata D. & Ajami R (1992), "Intanational Business.Theory and Practice". Macmillan
"Krugman P. & Obstfeld M. (1997) "Intunational Economics, Theory and Policy". Addison-Wesley