Financial Fragility and Instability in Indonesia
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Financial Fragility and Instability in Indonesia

Yasuyuki Matsumoto

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Financial Fragility and Instability in Indonesia

Yasuyuki Matsumoto

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About This Book

This highly relevant study provides an incisive analysis of a critical phase in recent East Asian financial history, exploring the underlying causes of the financial crisis that struck Indonesia during the second half of 1997.

Matsumoto's extensive commercial experience in Indonesian finance during these critical years, allows him to skilfully argue that the roots of the crisis lay in the period of capital liberalization undertaken during the boom years from 1994 to 1997 which encouraged the development of fragile and unstable financial structures, involving increased corporate leverage, reliance on external debt, and the introduction of riskier and more complicated financial instruments and transactions.

In-depth fieldwork data and four detailed case studies illuminate the microeconomic foundations of the crisis, showing how Indonesian capitalists sought to liquidate their Indonesian assets without losing control of their corporate empires, by taking advantage of increased access to foreign loans and complex financial re-engineering, actions which ultimately precipitated instability and crisis throughout the entire financial system. Finally, it reflects upon the policy implications of this episode, putting forward the case for comprehensive capital controls for open and developing economies until they establish appropriate financial institutions to monitor and manage the level of indebtedness and the volatility of capitalists' behaviour.

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Publisher
Routledge
Year
2007
ISBN
9781134150397
Edition
1

1 Indonesia’s external debt problem in the 1990s

The East Asian crisis and Indonesia

The devaluation of the Thai baht on 2 July 1997 set in motion a large-scale reversal of capital flows that developed into the East Asian financial crisis.1 This was a capital-account crisis rather than a conventional current-account crisis caused by large budget deficits, high rates of inflation and real currency appreciation (Furman and Stiglitz 1998; Krugman 1998a, 1999a; Yoshitomi and Staff of ADB Institute 2003). The aggregate capital account surplus of the five countries that were most affected (Indonesia, Korea, Malaysia, the Philippines and Thailand) fell sharply by US$90.9 billion from US$100.6 billion (9.27 per cent of Gross Domestic Product (GDP)) in 1996 to US$28.8 billion (4.52 per cent of GDP) in 1997. Furthermore, the capital account recorded a deficit of US$0.5 billion (0.07 per cent of GDP) in 1998.
This sudden and huge reversal was mainly due to the withdrawal of offshore commercial bank lending. Until the crisis, offshore commercial banks had made the largest contribution to the capital account surplus. Their contribution to net capital inflows into the five countries was US$53.2 billion (5.27 per cent of GDP) in 1995 and US$65.3 billion (6.02 per cent of GDP) in 1996. Once the crisis began, the banks led the reversal of capital flows by withdrawing US$25.6 billion (4.01 per cent of GDP) in 1997 and US$35.0 billion (4.61 per cent of GDP) in 1998 (Yoshitomi and Staff of ADB Institute 2003, p.69). This sudden and large-scale reversal of capital flows pushed the corporate sectors of the affected countries towards insolvency and brought an end to nearly three decades of uninterrupted growth.
The East Asian crisis not only set back economic development in Indonesia but also forced the country to restructure the social and political systems established by the Suharto regime. The crisis had a huge political impact throughout East Asia (Haggard 2000). However, Indonesia’s political crisis was the most severe, and this commingling of political and economic crises was a defining feature of the Indonesian collapse. The contraction of the economy in 1998, the inability of the government to intervene effectively, stalled negotiations with international financial authorities and evidence of massive corruption increased public frustration with the Suharto regime. The increasingly visible and lucrative business dealings of Suharto’s children had alienated former supporters of the regime during the 1990s. The economic crisis brought these concerns to a head, eventually leading to nationwide popular movements calling for an end to corruption, collusion, and nepotism (KKN). In March 1998, despite calls for Suharto to resign and the risk of anti-Chinese and antiregime violence across the archipelago, Suharto was reappointed as President of the Republic of Indonesia for a seventh term. Suharto appointed B. J. Habibie as Vice-President and provided ministerial positions to his eldest daughter and his long-time business associates. These appointments accelerated the collapse of the regime. Finally, the shooting of student protesters by the army led to an escalation of the student movement and eventually to the fall of the regime on 21 May 1998.
The Indonesian corporate sector was seriously damaged by the economic and political chaos of 1997–8. In 1997, 47.5 per cent of leading Indonesian non-financial companies suffered a net loss, and the average net loss per company was Rp. 27.3 billion (US$9.4 million). In 1998, these figures were even worse. Around 58.0 per cent of companies booked a net loss, and the average net losses increased in rupiah terms to Rp. 92.8 billion (US$9.1 million).2 This marked an unprecedented collapse of the corporate sector.3 The main cause of the reversal was the depreciation of the rupiah against major currencies which increased debt-service payments and the cost of imported inputs. Financial distress rapidly spread through the sector as demand contracted. The growth of real GDP fell from 7.8 per cent in 1996 to 4.7 per cent in 1997 (Table 4.9 in Chapter 4). The Indonesian economy contracted by 13.1 per cent in 1998.
These events came as a shock to long-term observers of the Indonesian economy. Average growth of real GDP was 7.2 per cent from 1990 to 1996 and output in the manufacturing sector grew by 9.8 per cent on average. Demand was driven by investment and private consumption. Investment grew by an average of 10.7 per cent per annum and private consumption by 7.8 per cent.4 Focusing on the investment boom of 1994–6, the average growth of real GDP was 7.8 per cent, in line with other rapidly growing Asian countries (e.g. 7.6 per cent in Thailand, 9.1 per cent in Malaysia and 8.2 per cent in South Korea). Although price inflation was higher than in most other East Asian countries, consumer prices still rose by less than 10 per cent (9.2 per cent in 1994, 8.6 per cent in 1995 and 6.5 per cent in 1996) (Table 4.9 in Chapter 4).
Balance-of-payments data for the ‘finance boom’ in Indonesia (between 1994 and the first half of 1997) reveal a gradual increase in the current account deficit from US$3.0 billion in 1994 to US$7.8 billion in 1996. However, this size of deficit was still controllable and was financed by a widening capital account surplus. This increased sharply from US$4.0 billion in 1994 to US$11.0 billion in 1996. The most important feature of this huge surplus is that it was created mainly by private-to-private capital inflows. Net private capital inflows were US$3.7 billion in 1994, US$10.3 billion in 1995, and US$11.5 billion in 1996. Official foreign exchange reserves increased sharply from US$13.2 billion in 1994 to US$19.1 billion in 1996 (Table 4.9 in Chapter 4). The growth of official reserves bolstered confidence among investors wary of Latin American-type current-account crises.
From the viewpoint of balance-of-payments management, the increase in private-to-private capital inflows could be seen as a response to fundamentals. However, the acceleration of private capital flows could also be interpreted as the introduction of more risk–return sensitive mobile capital into the financial structure. Official mobile capital, such as International Monetary Fund (IMF), World Bank and other CGI (Consultative Group on Indonesia) lending, is coordinated and cannot withdraw unexpectedly or suddenly given the purpose of their institutions.5 Private capital, on the other hand, is neither coordinated nor organized. Most individual investors do not possess structural power, yet, once they move in the same direction, private lenders acting as a group can exercise enormous structural power. Private capital movements are often volatile and subject to booms owing to investors’ ‘irrational exuberance’ (Shiller 2000; Yoshitomi and Staff of ADB Institute 2003).6 Reversals occur quickly, and policy makers do not have time to react. Furthermore, Indonesia is only one among many emerging market economies and investments in Indonesia account for only a small percentage of the total investment portfolio. Fund managers can easily move money to other countries to realize gains from remaining holdings or simply to cut losses. The decision-making process is also very rapid and cannot wait for policy makers’ responses.
By way of contrast, investments in equities and foreign direct investment do not create pressures for cash outflows. This is simply because equities do not entail scheduled payment commitments. On the contrary, if capital inflows consist of debt with payment commitments, such as offshore loans and bonds, trade account payables and offshore leases, the economy can experience a reversal of capital flows. In addition, if this offshore private debt finance is deeply integrated into the financial structure of the economy it results in it becoming fragile and unstable. During the finance boom, the Indonesian corporate sector accumulated offshore private debt and transformed the economy from robust to fragile and unstable while economic fundamentals remained essentially sound.
A number of studies link debt accumulation by the private sector to the liberalization policies that were actively pursued in East Asia’s crisis-affected countries in the 1980s and 1990s. In particular, the private sector’s external debt problem is viewed as a result of capital account liberalization. Indonesia undertook a dramatic deregulation of its financial sector in the 1980s and by the 1990s had one of the most liberalized financial markets in the world (Cole and Slade 1996; Pangestu 1996; Pincus and Ramli 2003). Deregulation policies were introduced between 1983 and 1989. In June 1983, bank credit ceilings and most interest rate controls were eliminated. In Desember 1987, a deregulation package for the investment and capital markets Paket 23 Desember 1987 (PAKDES I) was introduced, in which daily price controls on the Jakarta Stock Exchange were eliminated. In October 1988, the government introduced a major banking reform and deregulation package Paket 27 Oktober 1988 (PAKTO) that eliminated restrictions on the opening of new banks, branches and foreign joint-venture banks. In December 1988, the amendment and supplemental package Paket 20 Desember 1988 (PAKDES II) was introduced allowing foreign ownership of securities companies. The government refined PAKTO in March 1989 Paket 25 Maret 1989 (PAKMAR) and changed foreign borrowing restrictions on bank and non-bank financial institutions (NBFI) to controls on net open positions. It is not surprising that the monitoring system and regulatory framework was not put in place as quickly as the new financial products, services and institutions. In addition, Indonesia had already abolished practically all controls on foreign capital movements between 1966 and 1970 and has maintained the policy since then. In other words, Indonesia had already opened the capital account for financial flows out of the country and for most inflows from 1970 (Cole and Slade 1996, pp.3–4).
Balance-of-payments management has instead concentrated on restraining offshore borrowing by state companies and banks. In September 1991, the Coordinating Team for the Management of Offshore Commercial Loans (Tim Koordinasi Pengelolaan Pinjaman Komersian Luar Negeri) was established in order to control and monitor all offshore commercial loans for state companies, banks and projects (Presidential Decree No.39 (Keputusan Presiden 39)).7 In addition, both state and private banks were under strict control by Bank Indonesia, the central bank, for annual offshore borrowing quotas and timing to access offshore markets. However, although reporting to the team was required, private non-financial companies were able to obtain offshore loans to the extent that offshore banks were willing to lend to them. Therefore, the deregulation policies in the 1980s were not a direct reason for the sharp increase of external debt by the private non-financial companies in Indonesia.
What is most remarkable about the build up of private debt in the 1990s was the fact that cautious investors would have found many reasons for concern in Indonesia’s recent credit history. In August 1990, Bank Duta, one of the leading private banks owned by three of Suharto’s charitable foundations, violated net open position rules that had been imposed by Bank Indonesia in 1989 and took risky foreign exchange positions. The bank booked a US$420 million loss and was ultimately bailed out by Sudono Salim (Liem Sioe Liong) of the Salim Group and Prajogo Pangestu of the Barito Group, two close associates of Suharto. In 1992, Bank Summa, the flagship bank of the Summa Group (a sister business group of the Astra Group) and run as a purely family business by the Soeryadjaya family, failed due to excessive finance to its affiliated speculative and unprofitable businesses. As a result, the Soeryadjaya family lost ownership of the Astra Group.8 This was handed over to a consortium of mainly Indonesian Chinese business groups. Furthermore, in 1992 and 1993, other large business groups, such as the Bentoel Group and the Mantrust Group, went bankrupt due to excessive borrowing and failure of investments. In 1993, a controversial list of 26 major business groups that had accumulated more than Rp. 100 billion (US$48 million) in unpaid debt to the six state banks was leaked to the local press. This list confirmed widespread rumours that close associates of Suharto, including the Suharto family, had amassed huge fortunes at the expense of the state banks (Schwarz 1999). In 1994, the Golden Key Scandal erupted at Bapindo, one of the state banks, resulting in the loss of US$449 million to the state.9 In 1995, the Sinar Mas Group also booked a huge loss from derivatives transactions and the owner injected new funds in order to compensate for the loss. These events could have changed investors’ views of the Indonesian credit market in the 1990s. Yet, offshore investors enthusiastically brought their funds into Indonesia as if credit conditions had in fact improved during this period. As will be seen, the sudden rush of foreign loans into Indonesia during the period of the finance boom from 1994 to 1997 gave rise to important changes in financial structure, which would ultimately lead to the Indonesian economic crisis.

Review of Indonesian external debt data in the 1990s

All East Asian governments affected by the crisis had maintained macroeconomic stability and had prudently controlled external debt levels. In the case of Indonesia, since oil prices and state revenues began to decline in 1981, and state and quasi-state expenditures were put under pressure, the government had minimized the increase of its external debt by responding to the demands of international institutions, such as IMF, World Bank and CGI. Instead, the government expected the private sector to directly access offshore funds for investment. This work focuses on the private sector and, in particular, the corporate sector. The work defines the corporate sector as the private non-financial sector (or the private non-bank sector, depending on the availability of data) and focuses on the period from 1994 to the first half of 1997, a period that will be referred to as the finance boom. During this boom, the corporate sector obtained various types of finance on a huge scale from offshore as well as from domestic markets.
As shown in Tables 1.1, 1.2 and 1.3, during the 1990s and before the crisis in Indonesia, the state sector had limited the increase in external debt to an average of 5.3 per cent per annum from US$49.4 billion to US$62.0 billion. During the finance boom in Indonesia, the increase in the state sector’s external debt was only 2.7 per cent per annum, and that government, state companies (mainly the state oil company Pertamina and the national airline Garuda) and state banks managed to minimize the rate of increase in their external debt. However, even though total external debt expanded by an average of 11.3 per cent per annum from 1990 to 1996, the state sector’s share decreased from 78.6 per cent to 56.3 per cent.

Table 1.1 Indonesian external debt 1989–98 (billion US dollars)

Table 1.2 Annual growth of Indonesian external debt (% per annum)

Table 1.3 Share of Indonesian external debt (by sector) (%)

During the 1990s, external debt was driven by the private sector. During the 3 years of the finance boom, private sector offshore debt rose from US$19.9 billion to US$48.1 billion and its share of total external debt jumped from 24.7 per cent to 43.7 per cent.10 These figures indicate that Indonesia’s debt problem shifted from the state to the private sector in the 1990s.
Furthermore, it is clear that the external debt of the corporate sector was the most critical issue throughout the period and drove the growth of Indonesia’s external debt. The corporate sector’s external debt increased by an average of 25.9 per cent per annum from US$11.3 billion to US$39.7 billion. The share of this sector in total external debt also doubled from 18.0 per cent to 36.0 per cent. Dividing this period (1990 to 1996) into the first half (1990 to 1993) and the second half (1993 to 1996), the annual average growth of the private non-financial sector’s external debt for each half was 16.3 per cent and 30.9 per cent respectively. This second half constitutes the investment and finance boom in Indonesia.
Although the external debt of the financial sector increased from US$3.3 billion to US$11.5 billion from 1990 to 1996, most of this took place before the finance boom. Financial deregulation spurred foreign borrowing in the sector after 1988. However, by 1991, Bank Indonesia had moved to restrict new borrowing by banks.11 This form of capital controls proved to be reasonably successful. Ironically, it was the absence of controls on corporate external borrowing that ultimately destroyed the banking system rather than over-borrowing within the financial sector itself.
In sum, during the 1990s, the state restricted foreign debt while the private sector expanded overseas borrowing at an increasing rate. The distinctive characteristic of the Indonesian external debt problem during this period was the rapid debt build-up of the corporate debt. This contrasts with the situation in Thailand, for example, where debt was concentrated in the financial sector. As explained above, the corporate sector accumulated massive offshore debt after 1994. This work examines the reasons for the accumulation of corporate debt and the implications of debt build-up for the Indonesian economy.

External versus domestic private debt

Liberalization of the capital account was completed in 1970, long before the liberalization of the domestic financial sector began in the 1980s. The Indonesian private sector, therefore, in principle enjoyed unrestricted access to international financial markets for offshore fund raising. However, few private Indonesian companies were considered an acceptable risk in offshore markets in the 1970s and 1980s. Even leading international banks familiar with Indonesian risk since the beginning of New Order, financed only state companies and banks, such as Pertamina and BNI (Bank Negara Indonesia), and top private companies also needed foreign partners or governmental support to obtain offshore finance. In short, the private sector did not qualify for international credits prior to the 1990s. It needed Bank Indonesia or state banks to serve as intermediaries to access offshore funds.
Until the early 1980s, the state banks functioned as a funnel for pouring oil money into the corporate sector. They were provided with Bank Indonesia liquidity credits at subsidized interest rates and told to...

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