Indonesia: An Economy in Transition

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IndonesiaAn Economy in Transition

• A project by Zara Ahmed, Julia Dreier and Frank
  Ro

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Overview

• Indonesia A Brief History
• Overview of the Asian Financial Crisis
• Causes of the Crisis
• Indonesias Response to the Crisis
• Why Initial Reforms May Have Failed
• Indonesia Post-Crisis
• Potential Future Steps

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Indonesia

• Indonesia
• 17,500 islands, 200 million people
• GDP US935 billion
• GDP Per Capita US3800
• Unemployment 12
• Population Below Poverty Line 17.8

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Indonesia A Brief History

• 1945 Political instability and a deteriorating
  economy
• 1960s New Order Administration inflation comes
  down, foreign debt becomes manageable, problems
  begin to arise with oversight and regulation
• 1980s and 1990s foreign investment increases,
  GDP grows

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Indonesias Per Capita GDP and GDP Growth Rate
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The Asian Financial Crisis

• Large investment flow into Indonesia and other
  East Asian countries
• U.S. raises interest rate
• In early 1997, Thai baht is devalued

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The Asian Financial Crisis

• (1) Investors expect devaluation of the rupiah,
  due the increasing value of the US dollar and
  what occurred in Thailand.
• (2) Reluctance to borrow because loans will have
  to be repaid in more valuable dollars the IS
  curve shifts inwards.
• (3) Fall in invest depresses planned
  expenditure, which in turn depresses income from
  Y1 to Y2
• (4) The fall in income, which decreases money
  demanded
• (5) The reduced demand in money reduces the
  nominal interest rate
• (6) The nominal interest rate falls below the
  expected deflation, thus the real interest rate
  raises.

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The Asian Financial Crisis
Interest Rate
LM0
Real
Equilibrium
Nominal
Expected Deflation
IS0
IS1
Y0
Y1
YOutput
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Causes of the Crisis--Domestic

• Large external deficits
• Inflated property and stock market value
• Corrupt government
• High-risk lending--non performance loans
• Wealth concentrated in the hands of a few banks
• Pegged exchange rate

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Causes of the Crisis--International

• The Mexican Peso Crisis
• The U.S. Federal Reserve raised interest rates
• Currency speculation in Thailand, Malaysia, and
  other East Asian countries

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Indonesias Response to the CrisisInitial
Responses

• Widened the pegged exchange rate from 8-12
• Raised interest rates
• Floated the exchange rate
• Reduction of government spending

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Indonesias Second Response to the Crisis--The
Five Point Plan

• Stabilize the rupiah at a new equilibrium level
• Strengthen the fiscal policies and fiscal
  consolidation
• Reduce the current account deficit
• Support the banking sector
• Reassure the private sector about the stability
  of the economy

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IMFs Response to the Crisis

• IMF loans to Bank Indonesia
• An agreement to a balanced budget or surplus,
  maintain high nominal interest rates and restrict
  domestic credit
• Restructure financial markets
• Adopt good governance reforms and improve
  oversight

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Implementing IMF Reforms

• Indonesias proposed budget included a deficit
  instead of a surplus
• IMF claims that Indonesia was not serious about
  reform
• Creation of the Indonesian Bank Restructuring
  Agency

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Interpreting Indonesias Response Using the IS-LM
Model

• (1) If Y C(Y-T) I(r) GNX(e)
• (2) The government succeeds in raising the
  interest rate. However, two major problems
  arise a)The GDP decreases
  substantially b)While the interest rates
  increases, foreign investors still are cautious
  about investing in the country.
• (3) The crisis worsens, investment deteriorates,
  consumption and government expenditure would
  continue to decrease thus, the IS curve once
  again shifts inward towards IS2.
• (4) The Indonesian government continues to
  artificially increase the interest rates. Thus,
  they contract the money supply once again (moving
  to R2 and BP2)
• (5) Investors are still not enticed to invest
  with the even higher interest rates. Again, GDP
  falls and this process continues until the
  government realized that maintaining a fixed
  exchange rate was not going to work.

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Interpreting Indonesias Response Using the IS-LM
Model
LM2
Interest rate
Interest rate
LM1
LM0
BP2
R2
BP1
R1
BP0
R0
IS0
IS1
IS2
YGDP
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Why the IMF Reforms Failed

• IMF cannot rally market confidence
• IMF publicly announced that Indonesia had deep
  structural flaws
• IMF believed that reducing financial corruption
  would be enough to reassure creditors
• IMF advocated a contraction to fiscal policy
• Loan packages were not large enough
• Lengthy reform stipulations took up valuable
  government resources
• Initial loan programs and agreements were not
  made public

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Indonesia Post-Crisis

• Democrat election of Susilo Bambang Yudhoyono
• Focus on improving access to basic necessities
• Reduction of governments debt ratio
• Improved fiscal management and banking systems

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Potential Future Steps

• 1. Continue to improve the Bank of Indonesias
  transparency, independence, accountability, and
  credibility
• In order to maintain market confidence and
  attract additional foreign investment, continue
  to invest in local programs that create a more
  stable infrastructure and aid in the development
  of human capital
• Increase tax revenue
• Continue to reduce the debt to GDP ratio

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Questions?