Indonesian Banking Crisis

Gráinne McCarthy

  • Case Study

Casting around Southeast Asia in the 1990s, you’d have been hard pressed to hear warnings of pending doom. The Asian tigers were clocking up the kind of growth that made most rich countries jealous. Economists were speaking of the 21st century being the one that would belong to Asia. Foreign investment was pouring into the region. Like its neighbors, Indonesia was surfing the waves.

Even when the dominoes began to slide after the devaluation of the Thai baht on July 2, 1997, economists - both in the public and private sector - predicted Indonesia would weather the storm. How wrong they were. In the end, Indonesia was the hardest hit of all of the former Asian Tigers. Its economy, which grew 5.6% in 1997, contracted by a staggering 14% in 1998 as the country underwent its worst political and economic upheaval in over thirty. Inflation soared to over 80% in 1998 and short-term interest rates hit a high of just over 70% by September 1998 while the rupiah collapsed.

Long-standing problems in the banking sector played a major role in the havoc wreaked on the Indonesian economy. Corruption, lax banking supervision, perverse links between borrowers and lenders, government interference and heavy foreign borrowing that wasn’t hedged for the possibility of exchange rate fluctuation left a mountain of debt after the rupiah plunged. As a result, the ratio of foreign bank debt to gross domestic product (GDP) jumped to 140% in 1999 from around 35% before the crisis, rendering most of the banking system technically bankrupt.

As the economy began to unravel, consumers panicked and rushed to pull money out of the banks. Huge deposit runs put the banks’ capital bases under severe pressure. Bank Indonesia continued to print money rapidly - base money supply jumped 36% in December 1997, 22% in January 1998 and a further 11% in May 1998 - and pumped it into the flailing banking system in the form of liquidity support. It ultimately injected around 144 trillion rupiah into Indonesian banks at the height of the currency crisis.

"If banking is a battlefield, much of Asia has witnessed a bloodbath in recent months,” the Economist wrote in 1998, and nowhere was that more evident than in Indonesia. It was ``the world’s worst banking crisis since the 1970’s,’’ according to credit ratings agency Standard & Poor’s.

The economic crisis began to spiral into a political crisis that would eventually pile enough pressure on President Suharto to end his 32-year reign and step down on May 21, after bloody riots in Jakarta, that left as many as 1,200 dead.

History

After Thailand floated the baht in 1997, many economists in Asia were confidently predicting that Indonesia would withstand the storm. Its underlying macroeconomic economic situation was sound - a strong rupiah, stable inflation (6.5% in 1996), a conservative fiscal policy, a negligible official budget deficit, robust growth levels. Some economists had pointed out the big external imbalances and the large amount of short-term, dollar-denominated inflows, which, once reversed, caused the system to collapse. But theirs were lone voices. Most people seemed to predict Indonesia’s boom could continue indefinitely.

Instead the rupiah collapsed as did many other currencies in the region. In August 1997, after trying to stave off a wave of speculation, Bank Indonesia - the central bank - decided to leave the rupiah’s fate to the market, abandoning the trading band in which it had been allowed to move against the dollar, effectively devaluing the currency. Eventually the rupiah would lose over 80% of its value, an absolute meltdown that would far exceed the losses in other Asian currencies.

The key factor driving the collapse of the rupiah, and indeed other currencies in the region, was capital flight. According to classic economic theory, a pegged exchange rate regime can become vulnerable when cross-border capital flows are highly mobile. If investors suspect that the government will not or cannot maintain the peg, they often flee the currency, just as they did across Asia in 1997. This capital flight, in turn, deletes hard currency reserves and forces the devaluation they fear. Analysts reckon up to $40 billion fled Indonesia offshore, some to Singapore, some elsewhere. The rupiah’s slide undermined local confidence in the currency also. Many ordinary Indonesians changed their rupiah into dollars and stashed the hard currency under their mattresses.

The currency crisis quickly became a banking crisis. Because of the loan maturity mismatch and the currency mismatch - the use of short-term debt for fixed assets and unhedged external debt - banks and firms were vulnerable to sudden swings in international investors' confidence. In many ways even apart from this fundamental problem, the Indonesian banking crisis was inevitable as local banks were used to funding a number of enterprises that did not make money but were run by friends of President Suharto. He ruled for 32 years and ensured that his family and close associates were at the heart of many of the sprawling country’s strategic deals. If a foreign investor wanted to invest in an Indonesian venture, the way to do it was almost always to take a local minority partner, usually a Suharto family member or a friend. Suharto children were also business tycoons, owning and managing several large conglomerates listed on the Jakarta Stock Exchange.

The entire economic and legal system was designed to perpetuate this kind of corruption. While Indonesian legislation - in particular the bankruptcy law - has been recognized as respectable by international standards, the problem was always in the implementation. It was routine for judges to be bribed so that often cases never even got to court. The nature of the political system also allowed corruption to flourish. A sprawling country of 210 million people, Suharto very much ruled from the center, but at the same time with an understanding that officials at every point down the totem pole would cream something off the system. This became strikingly clear after the fall of Suharto when a report showed that some 30% of World Bank development funds during Suharto’s rule had apparently been siphoned off through corruption.

Investors mostly accepted this way of doing business. The returns simply outweighed the palm greasing of Suharto’s family and his cronies needed to secure the deal. The foreign investment helped fuel a booming period of economic expansion that seemed without end - the World Bank even spoke of Indonesia reaching developed country status by the end of the 1990s. After all, the Southeast Asian nation had booked 8% growth per year throughout much of the nineties.

Instead, by October 1997, Suharto called in the International Monetary Fund (IMF) and Indonesia became the second Asian tiger to turn, in desperation, to the Washington-based fund for help. After a frustrating series of discussions, the Jakarta government finally reached agreement with the Fund on a reform package totaling a whopping $43 billion, comprising loans from Indonesia’s traditional main lenders - the IMF, World Bank, Asian Developmet Bank and Japan - along with pledges of support from other countries around the world . But the IMF imposed conditions on Indonesia. In return for the IMF-led package, Indonesia had to agree to reform its legal systems, abolish monopolies, improve corporate governance, make the central bank independent, overhaul its banking system, raise interest rates to stabilize the rupiah, privatize businesses, as well as address a host of other issues.

The package was supposed to help restore confidence in the currency and the government, but it didn’t work. A major step included in the conditional IMF agreement was the decision to liquidate 16 banks, some of which were owned by well-connected businessmen and members of Suharto's family. The IMF’s then-Asia Pacific director Hubert Neiss described the banks as “rotten to the core.” When the banks were closed however, it sparked a massive rush by depositors fearful that their money wasn’t guaranteed. It was, by all accounts, the textbook case of how not to close banks. The situation was only partly remedied in January 1998 by a government guarantee of domestic bank deposits and liabilities, and the establishment of the Indonesian Bank Restructuring Agency (IBRA) to rehabilitate the banking system.

The government closed up to 70 banks and nationalized many others. IBRA, which was set up to help resuscitate the banking system, took over assets and bad loans with a face value of over $100 billion. Bank tycoons who had received billions in liquidity support from the central bank reached deals to pay the government back in the form of assets. With the help of the IMF, Indonesia put in place a system to bail out the banks and recapitalize them via issuing government bonds which sat on bank balance sheets as assets. This restructuring has left much of the banking system in government hands and left the state saddled with the interest cost of the bonds each year. Non performing loans were estimated at a staggering 70% of GDP in 1999. When the smoke cleared, the total number of banks had declined from 238 pre-crisis to 162 in 1999.

Lesson Learned

1) Corruption had weakened the banking system. Perhaps foremost, the banking system was woefully weak, corrupt and overcrowded. Many of the state banks were little more than cash cows for the Suharto family and private banks were often established primarily as vehicles to pump cash into sister companies within the same conglomerate. The growing Indonesian middle class, those most likely to deposit funds in the banking system, still did so, not least due to a sense that the government would step into protect consumers if there was ever a need. In this sense, there was an implicit government guarantee. Even after the fall of Suharto, the influence of his political party on bank lending was still demonstrated vividly with the Bank Bali scandal, which centered around the transfer in 1999 of around $80 million out of the bank to a company linked to the then-ruling Golkar Party. The money was ostensibly paid as a debt-collection fee on government-guaranteed loans extended by Bank Bali. The news of the missing money only came out when British bank Standard Chartered attempted to buy a minority stake in Bank Bali in 1999 only to find that roughly $80 million was missing.

2) The role of “moral hazard.” Moral hazard is created when governments offer guarantees that encourage bankers to make loans to borrowers who are incapable of paying them back. In Indonesia, the government encouraged local companies to borrow without considering the risk, hinting that if trouble ever did raise its ugly head, the government would step in to help out. And many foreign bankers were encouraged to make these highly imprudent loans to over-leveraged Indonesian companies. Foreign capital rushed into Indonesia during the boom years of the 1990s. At the back of many foreign banks’ minds was a sense that the IMF would step in and bail out Indonesia if ever there was a crisis. This is also moral hazard.

3) The lack of transparency in banking regulations. Just as in other emerging market economies, market watchers also blamed a lack of transparency on the part of the central bank for what happened since it didn’t publish commercial banks’ short-term debt levels. Many were surprised by the magnitude of the short-term debt of Indonesian companies because it wasn’t apparent on balance sheets.

4) The legal system itself was chronically weak. Judges were often poorly educated, corrupt and ill informed about complex financial loan arrangements. This was to prove a major stumbling block to Indonesia’s recovery, as foreign banks would find it near impossible to recover debt from delinquent debtors via the bankruptcy courts. As noted earlier, it’s not much good to have an impressive law if it’s not being implemented.

5) The manner in which the banks were closed sparked major consumer panic. Instead of announcing why they were being closed - and putting a deposit guarantee in place - Suharto simply shut 16 banks down in November 1997. People rushed to withdraw deposits from the banks in question and from other banks, while rich investors whipped cash overseas. Bank Indonesia estimated that ultimately some $40 billion fled offshore, fearing a crackdown on corruption and a meltdown in the rupiah. It soon became clear that the supposedly confidence-building IMF program had done nothing of the sort. The rupiah continued to dive, and the stock market to plunge. The IMF has since admitted that the manner in which the banks were closed was wrong. The government quietly shut them, instead of informing the public of the reasons why. It also closed the banks before any mechanism was in place to guarantee deposits. The situation was only partly remedied in January 1998 by a government guarantee of domestic bank deposits and liabilities, and the establishment of IBRA to rehabilitate the banking system.

6) High interest rates virtually killed the real economy. Growth contracted by 14% in 1998 - putting further pressure on the banks. Short-term rates jumped as high as 70% as part of the IMF-mandated medicine to support the currency. That caused the spread between bank deposit and lending rates to soar as commercial and state banks also raised their lending rates in response to central bank’s efforts to bolster the rupiah. This phenomenon is known as ‘negative spread’ under which banks have to pay out more in deposit rates than they earn in lending rates.

7) The bailout left the government with a whopping interest bill on the bonds it issued to recapitalize the banks and left much of the banking system in public hands. The government ultimately spent a staggering $68 billion in money pumped into the banks in 1997 and 1998 and bonds issued to recapitalize the banks and raise their capital adequacy levels to 4% (international minimum average is 8%). In order to quality for state financial assistance, banks had to have a capital-adequacy ratio of between minus 25% and 4%. Bank owners also had to come up with 20% of the recapitalization funds, with the government contributing the rest. A capital-adequacy ratio is a typical measure of a bank's health -- the higher the ratio, the sounder the bank. Many of the banks that didn’t make the grade were closed. Despite the massive bill, Indonesian banks remain fragile and many still aren't lending again.

Conclusion

The banking system is still not out of the woods. After nearly two years of trying, Indonesia finally sold Bank Central Asia - arguably its most attractive bank asset - to Farindo Investments, in March 2002. But the sale left many observers wondering what it would do for the country’s weak banking system, given questions about its new owners - who have no previous experience in the industry. Farindo’s backers include Farallon Capital, a low-profile private U.S. investment fund and the reclusive Hartono brothers, owners of Indonesia’s third-largest cigarette manufacturer. A rival consortium led by the UK’s Standard Chartered PLC was the unexpected loser.

Adding to the sense that Indonesia’ s banking crisis has been slow-burning rather than swift, there are still 100 or more bankers accused of misusing Bank Indonesia liquidity funds disbursed during the 1997-98 crisis. Analysts estimate the state suffered more than 137 trillion rupiah (about $13.3 billion) in losses due to manipulation of central bank funds, much of which is suspected to have been taken out of the country, amid allegations of kickbacks to government and central bank officials. Law enforcers were slow to follow up the corruption, despite pressure from the IMF and World Bank.

And the central bank itself has seen its credibility battered: also in March, the central bank governor was convicted of corruption and sentenced to a three-year prison term for his alleged part in the Bank Bali scandal. The governor - Sjahril Sabirin - was accused of overseeing the illegal transfer out of the bank to Golkar-linked company, with the funds reportedly to go towards financing President B.J. Habibie’s reelection bid. Sabirin has always denied the charges and initially refused to step down from the helm of the central bank, although he has since done so.

But more than four years after Suharto’s government signed its first agreement with the IMF, Indonesia - now ruled by democratically elected President Megawati Sukarnoputri - is still a fragile place. Instability continues to haunt the country and foreign direct investment has dwindled to almost negligible levels. It has been further damaged by a series of bombings across the country, in particular the devestating bombing of two nightclubs in Bali in October 2002. While other Asian countries have to some extent come roaring back, Indonesia remains off many investors radar screens.

Still, foreign banks are interested in investing and the government is leaving the IMF program at the end of 2003. Bank stocks have been rallying on the Jakarta stock exchange and IBRA is set to be wound up its operations next year. Even after the Bank Bali scandal, Standard Chartered tried again with BCA and has said it is still interested in expanding in Indonesia.

Local and foreign banks have expanded aggressively in the highly competitive retail market and see significant potential in the large population of around 210 million. But the banks still rely heavily on interest income from the government bonds issued to refinance the banks. According to a central bank document, government bonds contributed around 45% of Indonesian banks' total interest income in 2002, meaning the banks had not effectively functioned as intermediary institutions helping stimulate growth.

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