Indonesia: An Economy in Transition A project by: Zara Ahmed, Julia Dreier and Frank Ro.

Indonesia:Indonesia:An Economy in TransitionAn Economy in Transition

A project by: Zara Ahmed, Julia Dreier and A project by: Zara Ahmed, Julia Dreier and Frank RoFrank Ro

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Overview:Overview:• Indonesia: A Brief HistoryIndonesia: A Brief History• Overview of the Asian Financial CrisisOverview of the Asian Financial Crisis• Causes of the CrisisCauses of the Crisis• Indonesia’s Response to the CrisisIndonesia’s Response to the Crisis• Why Initial Reforms May Have FailedWhy Initial Reforms May Have Failed• Indonesia Post-CrisisIndonesia Post-Crisis• Potential Future StepsPotential Future Steps



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IndonesiaIndonesia•17,500 islands, 200 million 17,500 islands, 200 million peoplepeople

•GDP: US$935 billion GDP: US$935 billion

•GDP Per Capita: US$3800GDP Per Capita: US$3800

•Unemployment: 12%Unemployment: 12%

•Population Below Poverty Population Below Poverty Line: 17.8%Line: 17.8%

Indonesia: A Brief Indonesia: A Brief HistoryHistory

• 1945: Political instability and a 1945: Political instability and a deteriorating economydeteriorating economy

• 1960s: New Order Administration: 1960s: New Order Administration: inflation comes down, foreign debt inflation comes down, foreign debt becomes manageable, problems becomes manageable, problems begin to arise with oversight and begin to arise with oversight and regulationregulation

• 1980s and 1990s: foreign 1980s and 1990s: foreign investment increases, GDP growsinvestment increases, GDP grows



Indonesia’s Per Capita Indonesia’s Per Capita GDP and GDP Growth GDP and GDP Growth

RateRate

The Asian Financial The Asian Financial CrisisCrisis

• Large investment flow into Indonesia and other East Asian countries

• U.S. raises interest rate

• In early 1997, Thai baht is devalued




(1)(1) Investors expect devaluation of the Investors expect devaluation of the rupiah, due the rupiah, due the increasing value of the US increasing value of the US dollar and what occurred dollar and what occurred in Thailand. in Thailand.

(2)(2) Reluctance to borrow: because loans Reluctance to borrow: because loans will have to be will have to be repaid in more valuable dollars repaid in more valuable dollars the IS curve shifts the IS curve shifts inwards.inwards.

(3)(3) Fall in invest: depresses planned Fall in invest: depresses planned expenditure, which expenditure, which in turn depresses income in turn depresses income from Yfrom Y11 to Y to Y22

(4)(4) The fall in income, which decreases The fall in income, which decreases money money demandeddemanded

(5)(5) The reduced demand in money The reduced demand in money reduces the nominal reduces the nominal interest rateinterest rate

(6)(6) The nominal interest rate falls below The nominal interest rate falls below the expected the expected deflation, thus the real deflation, thus the real interest rate raises.interest rate raises.


Interest Interest RateRate

RealReal

EquilibriEquilibriumum

NominalNominal Expected Expected

DeflationDeflation

Y=OutputY=Output

LLMM00

ISIS00ISIS11

YY00YY11

Causes of the Crisis--Causes of the Crisis--DomesticDomestic

• Large external deficitsLarge external deficits• Inflated property and Inflated property and

stock market valuestock market value• Corrupt governmentCorrupt government• High-risk lending--non High-risk lending--non

performance loansperformance loans• Wealth concentrated Wealth concentrated

in the hands of a few in the hands of a few banksbanks

• Pegged exchange ratePegged exchange rate



Causes of the Crisis--Causes of the Crisis--InternationalInternational

• The Mexican Peso The Mexican Peso CrisisCrisis

• The U.S. Federal The U.S. Federal Reserve raised Reserve raised interest ratesinterest rates

• Currency Currency speculation in speculation in Thailand, Malaysia, Thailand, Malaysia, and other East and other East Asian countriesAsian countries



Indonesia’s Response to Indonesia’s Response to the Crisis:the Crisis:

Initial Responses Initial Responses • Widened the pegged exchange Widened the pegged exchange

rate from 8%-12%rate from 8%-12%• Raised interest ratesRaised interest rates• Floated the exchange rateFloated the exchange rate• Reduction of government Reduction of government

spendingspending



Indonesia’s Second Indonesia’s Second Response to the Crisis--Response to the Crisis--

The Five Point PlanThe Five Point Plan• Stabilize the rupiah at a new Stabilize the rupiah at a new

equilibrium levelequilibrium level• Strengthen the fiscal policies and Strengthen the fiscal policies and

fiscal consolidationfiscal consolidation• Reduce the current account deficitReduce the current account deficit• Support the banking sectorSupport the banking sector• Reassure the private sector about Reassure the private sector about

the stability of the economythe stability of the economy



IMF’s Response to IMF’s Response to the Crisisthe Crisis

• IMF loans to Bank IMF loans to Bank IndonesiaIndonesia

• An agreement to a An agreement to a balanced budget or balanced budget or surplus, maintain high surplus, maintain high nominal interest rates nominal interest rates and restrict domestic and restrict domestic creditcredit

• Restructure financial Restructure financial marketsmarkets

• Adopt good governance Adopt good governance reforms and improve reforms and improve oversightoversight



Implementing IMF Implementing IMF ReformsReforms

• Indonesia’s proposed budget Indonesia’s proposed budget included a deficit instead of a included a deficit instead of a surplussurplus

• IMF claims that Indonesia was not IMF claims that Indonesia was not serious about reformserious about reform

• Creation of the Indonesian Bank Creation of the Indonesian Bank Restructuring AgencyRestructuring Agency



Interpreting Indonesia’s Interpreting Indonesia’s Response Using the IS-LM Response Using the IS-LM

ModelModel(1)(1) If If Y= C(Y-T)+ I(r)+ G+NX(eY= C(Y-T)+ I(r)+ G+NX(e) ) (2)(2) The government succeeds in raising the interest rate. The government succeeds in raising the interest rate.

However, two However, two major problems arise:major problems arise:a)The GDP decreases substantiallya)The GDP decreases substantially b)While b)While the interest rates increases, foreign investors still are cautious the interest rates increases, foreign investors still are cautious about about investing in the country. investing in the country.

(3)(3) The crisis worsens, investment deteriorates, consumption The crisis worsens, investment deteriorates, consumption and and government expenditure would continue to government expenditure would continue to decrease; thus, the IS curve decrease; thus, the IS curve once again shifts inward towards ISonce again shifts inward towards IS22. .

(4)(4) The Indonesian government continues to artificially The Indonesian government continues to artificially increase the interest increase the interest rates. Thus, they contract the money supply rates. Thus, they contract the money supply once again (moving to Ronce again (moving to R22 and BPand BP22) )

(5)(5) Investors are still not enticed to invest with the even Investors are still not enticed to invest with the even higher interest higher interest rates. Again, GDP falls and this process continues rates. Again, GDP falls and this process continues until the government until the government realized that maintaining a fixed exchange realized that maintaining a fixed exchange rate was not going to work. rate was not going to work.



Interpreting Indonesia’s Interpreting Indonesia’s Response Using the IS-LM Response Using the IS-LM

ModelModel Interest Interest raterate

Y=GDPY=GDP

LM2

Interest Interest raterate

LM1

LM0

IS0

IS1

IS2

BP0

BP1

BP2 R2

R1

R0

Why the IMF Reforms Why the IMF Reforms FailedFailed• IMF cannot rally market confidenceIMF cannot rally market confidence

• IMF publicly announced that Indonesia had IMF publicly announced that Indonesia had deep structural flawsdeep structural flaws

• IMF believed that reducing financial IMF believed that reducing financial corruption would be enough to reassure corruption would be enough to reassure creditorscreditors

• IMF advocated a contraction to fiscal policyIMF advocated a contraction to fiscal policy• Loan packages were not large enoughLoan packages were not large enough• Lengthy reform stipulations took up valuable Lengthy reform stipulations took up valuable

government resourcesgovernment resources• Initial loan programs and agreements were Initial loan programs and agreements were

not made publicnot made public



Indonesia Post-Indonesia Post-CrisisCrisis

• Democrat election of Susilo Democrat election of Susilo Bambang YudhoyonoBambang Yudhoyono

• Focus on improving access to Focus on improving access to basic necessitiesbasic necessities

• Reduction of government’s Reduction of government’s debt ratiodebt ratio

• Improved fiscal management Improved fiscal management and banking systemsand banking systems



Potential Future Potential Future StepsSteps1.1. Continue to improve the Bank of Continue to improve the Bank of

Indonesia’s transparency, independence, Indonesia’s transparency, independence, accountability, and credibilityaccountability, and credibility

2.2. In order to maintain market confidence In order to maintain market confidence and attract additional foreign investment, and attract additional foreign investment, continue to invest in local programs that continue to invest in local programs that create a more stable infrastructure and create a more stable infrastructure and aid in the development of human capitalaid in the development of human capital

3.3. Increase tax revenue Increase tax revenue

4.4. Continue to reduce the debt to GDP ratioContinue to reduce the debt to GDP ratio



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Indonesia: An Economy in Transition A project by: Zara Ahmed, Julia Dreier and Frank Ro.

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