MSc Political Science, thesis
Better foundations or good policy?
How Brazil and Indonesia weathered the global financial crisis
Roy van der Meij
5966477
Geoffrey Underhill
30-09-2015
Content
Introduction 3
Financial crises and emerging market economies 8
Macroeconomic fundamentals 16 Policy options 18 Research design 21 Indonesia 26 Macroeconomic fundamentals 28 Policy 38 Brazil 46 Macroeconomic fundamentals 48 Policy 58 Analysis 64 Conclusion 70 Literature 72
Introduction
Whereas previous financial crises often began in emerging markets, the Global Financial Crisis of 2007-09 originated in the United States of America, arguably the financial centre of the world. Low interest rates and an overly optimistic outlook had contributed to a bubble in the real estate market that was made all the more volatile by deregulation and less than prudent lending conditions. When the bubble did indeed burst at the end of 2007 not only mortgage institutions, but also major banks and insurance companies went down. Bad loans and toxic financial products had
permeated those institutions to such a level that trust among companies and banks was at near-zero levels, which led to a rapid deceleration of credit provision. Thus, the housing crisis became a fullblown economic crisis and spread to other countries with strong links with the United States. The United Kingdom and Iceland for example had similarly deregulated their financial sector in the previous decade. The global fall in demand led to a collapse of international trade, which put increased pressure on emerging countries’ balance sheets (Rose and Spiegel, 2009). Furthermore, the uncertainty and subsequent repricing of risk among the banking sector caused international credit lines to dry up. Emerging markets were through no fault of their own entangled in the now global financial crisis.
This is how countries like Indonesia and Brazil ended up in the crisis. Neither of them had major stakes in the Western banks that held the toxic debt instruments, but the fall in demand and general panic in the financial markets caused them to suffer rcessions anyway. In Indonesia, the stock market fell by nearly 10 percent on 8 october 2008, causing officials to halt trading that day. At the end of the year, the stock market had fallen to nearly half its original size. The exchange rate of
Indonesia’s currency, the rupiah, fell by 30 percent that same year (Basri, 2013: 6). These developments had profound effects on the real economy. Exports dropped from around 13000 USD million to slightly over 7000 USD million. As a result, GDP growth slowed down near the end of 2008 (Basri, 2013: 6). Similarly, on the other side of the world, Brazil was also deeply affected by the financial crisis. Like Indonesia, its stock market took a plunge, as did its exchange rate and international trade volumes (Hoffman, 2011). There was the potential for yet another ‘lost decade’ with a sagging economy, high unemployment and growing poverty rates for these emerging markets.
But that didn’t happen. Indonesia and Brazil both recovered remarkably fast, and they weren’t the only emerging market economies to do so. The Indonesian GDP growth remained positive even during the worst of the crisis, and was back at an impressive 6.2% as early as 2010 (World Bank data, 2015). Its stock price and exchange rate also quickly recovered to their pre-crisis levels (Hadiwibowo, 2009 : 9-10). Brazil recovered even faster. The economy began to grow again in March 2009, and in 2010 the economy was well on its way to recovery (Hoffman, 2011: 24). Emerging markets outperformed many of the developing countries that were at the center of the crisis. Developed countries like the United States, Germany and France for instance took until late 2010 to come back to very moderate GDP growth rates (Figure 1). In emerging markets the effects from the global financial crisis didn’t carry over as much into the real economy. The admittedly already high
unemployment rates in Brazil and Indonesia remained relatively stable, with only a 2% spike in Brazil in 2009 (Ibidem: 24). In 2010 it was business-as-usual again in many emerging economies, while developing nations were still grappling with the fallout from the crisis.
Figure 1: Real GDP growth in annual % Source: World Economic Outlook, 2015 -8 -6 -4 -2 0 2 4 6 8 10 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Brazil Germany Indonesia United States
Maybe even more remarkable than the emerging markets outperforming
developed countries is the fact that they outperformed themselves in a way. Emerging markets have weathered many different economic crises during the last decades that they either caused themselves or that had originated elsewhere and spread throughout a region. Brazil got caught up in the Tequila that started with Mexico defaulting in 1994 and led to banking and currency crises throughout the region. When Brazil was unable to service its debt, it had to turn to the IMF for help. Similarly, Indonesia was one of the most affected countries in the Asian Financial Crisis in the late nineties, which started with the floating of the exchange rate of Thailand, and then set off a chain reaction of busts and defaults throughout the region. Many East Asian
countries, including Indonesia, were forced to turn to the IMF. The financial crises in both countries had had profound effects on their real economies, with record-high unemployment and poverty rates. The contrast with the 2008-09 crisis is huge.
The main question of this thesis is: How and why were the so long crisisprone emerging market economies able to avoid being a central part of the problem and origin of the global financial crisis of 2007-09?
There are three possible explanations for this. The first hypothesis is that emerging economies such as Indonesia and Brazil were simply not as severely hit during the crisis, merely experiencing a setback by a temporary lack of trade and the drying up of finance. Certainly, economic growth was way down, dropping more than 5% in for instance China and India in less than two years (Goldstein ea, 2009: 3). and exports for emerging Asian countries dropped by an annual rate of 70%. But
emerging markets, according to this hypothesis, were decoupled from the world economy enough that the crisis was not severe as it could have been. For one, banks in these economies didn’t hold much of the loan instruments and toxic debt that had caused the crisis to begin with. Furthermore, intra-regional trade and trading amongst each other is a considerable share of total exports for emerging economies, making the fall in demand from Western nations less influential, the concurrent fall in prices notwithstanding.
A second hypothesis is that the macro-economic fundamentals of emerging economies were much stronger at the onset of the 2008 crisis than during previous financial crises. Certain fundamentals make a country more likely to experience a financial crisis like Latin American governments having large amounts of debt compared to their GDP, or countries holding a large amount of foreign-denominated
private debt, making them susceptible to sudden reversals of credit streams. Many times a financial crisis didn’t originate in the country itself. Instead, the crisis spread throughout a region. Having low reserves especially when in combination with a fixed exchange rate makes this type of contamination more likely. Emerging countries before previous crises like the Asian Financial Crisis or the Tequila and subsequent currency crisis had characteristics that made it more likely for a crisis to happen and to have severe consequences. Before the 2008-09 financial crisis the fundamentals of emeriging countries were a lot stronger. The global character of the 2008 financial crisis meant that most emerging countries still experienced setbacks, but not as severely as before and because of that they were able to rebound a lot faster.
The third and final hypothesis is that economic policy of emerging countries both before and during the crisis was more efficient than during previous crises. Policymakers had fixed many of the problems that made a financial crisis more likely. Banking regulations were tighter and lending conditions were made more prudent. Specific measures were in place to make sure that foreign capital could not leave the country as suddenly, thus abating the sudden-stop problem. What’s more,
governments and policymakers acted more proactive during the crisis, and were thus able to ward off the worst.
Even though I won’t outright reject the first hypothesis, the main focus of this thesis will be on the latter two. In order to find out which of the hypotheses holds the most water I will conduct a comparative case study of the aforementioned Indonesia and Brazil. Ever since the global financial crisis ended five years ago, a sizeable amount of literature has appeared on the performance of emerging market economies, either constituting large-n research or extensive case studies. Most case studies are either about a single country, like Reddy (2010) on India or compare an emerging market with a developed nation, like Hoffman’s (2011) comparison of Germany and Brazil. In this thesis however, I’m more concerned with a comparison of emerging countries with their former selves. Did these countries have fundamentally stronger and more diversified economies than during previous decades or was better policy implemented before and during the 2008 crisis? Indonesia and Brazil are similar in the sense that both countries have experienced crises in the past that originated elsewhere, but still had profound effects on their economy. The two are different when it comes to their macroeconomic fundamentals: Brazil has always had a
Indonesia has historically had monetary problems, wherein manipulating the interest rates seldom had the intended effect. By comparing these countries before and during the 2008/09 financial crisis, holding in mind their different economic histories, I hope to find commonalities in their experience that might explain why emerging markets performed so much better during the global financial crisis.
The thesis will proceed as follows. In the following two sections I will outlay the theory behind the macroeconomic fundamentals. What characteristics make a country more liable to financial crisis, and just as importantly in light of our main question, what characteristics make a country vulnerable to financial contagion from other countries in the region? In the next section, I will turn toward the policy hypothesis. Even though policy is often country- and situationspecific, what might good crisis-preventing policy mean for emerging markets? The next section is the research design, outlining both my methodological choices and the way I’m going to compare the two countries. Then I will present the case studies of respectively Indonesia and Brazil, outlining their macroeconomic situation and policy choices. In the analysis I will compare the experiences of these two emerging markets and try to find commonalities and differences in their experiences. The conclusion will contain a short summary of the findings, along with implications for further research.
Financial crises and emerging market economies
A financial crisis means that the financial institutions and assets of a country lose nominal value rapidly. The value of the stock market goes down significantly in a very short amount of time and the largescale defaulting on loans and bankruptcies puts pressure on banks. Uncertainty about the future of banks can cause bank runs, where people en masse try to pull their money out of a bank. The fall of the stock market and banking crises further deteriorate the economic situation. That’s why financial crises have often been said to have a downward spiraling effect. Largescale financial crises since the 1929 Wall Street crash have mostly taken place in emerging economies with sometimes entire regions suffering economic downturn.
In emerging countries it’s not only the domestic institutions that cause problems, but also the drying up and pulling out of international credit lines, which are often essential to the functioning of these economies. Calvo has called this the ‘sudden stop’ problem (Calvo, 1998). A sudden reversal of capital inflows puts pressure on the real exchange rate, causing central banks to intervene in the foreign exchange market, especially in the case of a fixed exchange rate (Ib: 8–9). On top of that, the public will try to lessen their holdings of foreign-denominated assets and where possible converting them, and in doing so increasing interest rates (Ib). This means that even when a country is economically healthy, a sudden stop on capital inflows can still lead to a sizeable drop in output and growth. In this section I will briefly explain three basic types of finanical crises in emerging market economies, and the channels via which a crisis can spread from country to country. This will inform the analysis of which macroecomic indicators are important and which policy to implement before and during a crisis in the case studies.
Government debt crisis
A government debt crisis occurs when a country can no longer pay back all loans to foreign entities. This happened to a wide set of low-income and developing countries in the eighties in the appropriately called Latin American Debt Crisis. Because of the low level of incomes and savings in emerging economies, there is generally too little capital to finance domestic development. Financing then comes in the form of foreign bank loans, bond finance and foreign direct investment. Debt-to-GDP ratios at the
long as both the lenders and the borrowers did well enough. But in the case of a financial shock lenders start to call back loans, it often turns out that countries are not able to pay, as happened in 1982 in Mexico and subsequently most Latin American countries.
It is easy to blame bad government policies for a government debt crisis and they certainly do carry a great deal of the blame. More interesting for the purposes of this thesis however is to look at the supply of the loans. Why did international
financial institutions lend quite so easily? The answer is twofold: an excess amount of money and a lack of profitable, secure investment opportunities. From 1973 onwards the enormous profits of the OPEC countries were stored at Western banks, which ran out of ‘normal’, more secure places to invest and thus recycled these petroldollars in the promising Latin American countries (Edwards, 1999). Similarly, prior to 2008 there was an excess supply of money from emerging countries that had become richer over the last decade and a lack of secure places to invest, which may have contributed to the boom in lending in the mortgage market.
Currency Crises
Currency crises, also known as balance-of-payments crises, occur when there’s a question of whether the central bank has enough foreign reserves to maintain a fixed exchange rate. It is often brought about or worsened by so-called speculative attacks. These are one of the major causes of the Asian financial crisis of 1997 that hit
Indonesia particularly hard. Speculative attacks happen when speculators sense that a country’s economy is going to be in trouble. In that case there is significant pressure on that currency to devalue. In the case of a fixed exchange rate regime or if it wants to offset the problems that depreciation would bring, the central bank will sell its foreign currency holdings and buy its own. However, the central bank’s foreign currency supply is necessarily limited and if it runs out the bank will have no choice but to float their exchange rate anyway. When speculators perceive this is going to happen in a country, they will borrow large amounts of its currency, convert it in the foreign exchange market, and then wait for the inevitable floating to happen, so that when they convert back, they will earn some big bucks by the difference in yields (Krugman, 1979: 312).
These speculative attacks have two major negative effects for the country in question. Firstly, they are self-fulfilling. The borrowing of currency and converting it
in foreign money is making the central bank run out of reserves even faster. Secondly, they are of almost no cost to the speculators themselves. If the central bank is able to avert the attack, the speculators will simply convert the currency back and lose
virtually no money in the process (Ib). Thus, largescale speculative attacks can have a devastating effect on a country’s currency and through that channel on their real economy. This is precisely what happened in Thailand in 1997 when its high interest rates turned out to be based on speculative lending in the real estate market.
Speculators smelled blood, attacked Thailand and the government was forced to float their currency, which along with their untenable amount of external debt contributed to the Asian Financial Crisis.
The type of speculative attack described above is called a “first-generation” model and is characterized by the fiscal imbalance being perpetuated. It has thus been rightfully criticized for taking governments and central banks as being way too rigid. It also fails in explaining largescale regional crises. “Second-generation” models, like the one by Obstfelt (1986) emphasize a greater role for the self-fulfilling nature of speculative attacks. A government maintaining a fixed exchange rate while there’s a rosy outlook is easy, but when expectations of devaluation, be they rational or irrational, are high, that event is more likely to happen. Further explantions of currency crises along those lines emphasize the role of moral hazard or government guarantees in exacerbating the dangers of unfettered speculation.
Banking and ‘Twin’ Crises
A systemic banking crisis occurs when the major financial institutions of a country are experiencing a large amount of defaults and they struggle to repay the debt burden on time. The reserves of the banking system and the central bank are exhausted rapidly. Bank runs wherein the public scrambles to get their deposits out in time, thus worsening the crisis even further, can but don’t necessarily have to be an element. (Laeven and Valencia, 2008: 5). Banks will either fall or have to be bailed out by the government, as happened in numerous countries in the global financial crisis.
Many countries that experienced a banking crisis also experienced a currency crisis at roughly the same time (Kaminsky and Reinhart, 1997). Both banking and currency crises are caused by the same deficiencies in the economy, particularly the overvaluation of the exchange rate and incompatible monetary and fiscal policy (Ib:
creditors. In emerging countries the regulation and supervision of banks is often lacking, as was the case in many Asian countries during the late nineties. As such, increased access to short-term loans and less than prudent conditions may cause an asset boom. When a recession hits it affects both the domestic banking sector and, in the case of a fixed exchange rate, the reserves. While both crises may have separate direct causes, one fuels the other: the downfall of the banking sector makes
speculators hungry and the exchange rate becomes increasingly untenable (Ib). The situation then becomes something of an economical vicous circle of death. The more the banking sector has liabilities it cannot guarantee, the more vulnerable the entire economy is (Ib.). That’s why Kaminsky and Reinhart dubbed these ‘twin crises’. That is exactly what happened not just to the Asian countries in the late nineties, but also to banks in developed countries that held large amounts of the worthless CDOs during the 2008 financial crisis.
Contagion
The emerging markets during the global financial crisis of 2007 and most of the affected countries in Latin American debt crisis of the 1980s and the Asian Financial Crisis of the late 1990s were at not the origin of the crisis. That is to say, the initial shock to the financial system occurred in one country and then gradually spread through the region, or in the case of 2007, throughout the entire world. This process of a financial crisis being transmitted to other countries that may not have been directly affected by the direct cause of the crisis is called financial contagion.
It should be noted though that the very existence of financial contagion is a contentious issue among economists. The phenomena that are commonly associated with contagion could also be explained as manifestations of the same common shock across different countries (Rose and Spiegel, 2009: 3). A common shock in one country might make investors and speculators more careful about other countries that have similar economic fundamentals and reduce their holdings there (Fratzscher, 1998: 667). These interpretations downplay the role of international spillover effects. While this interpretation of contagion may shed light on some aspects of the Asian and Latin American crises, it can’t explain the transmission of the US credit crunch to emerging economies, which had little or nothing to do with the initial shock.
Contagion then is defined here as the transmission of a financial crisis due to its interdependence with countries that are already experiencing a crisis (after Fratzscher,
2002: 7). Countries can be interdependent both in the real economy and in the financial system, which are both ways for a crisis to spread from one country to the next. Below is a summary of the various channels of transmission of a crisis.
Contagion: the trade channel
Perhaps the most intuitive way for a crisis to spread from one country to the next is via international trade. When a country is hit by an economic crisis, its demand for imports goes down. The current account of the exporters is then negatively affected, and economic growth hampered, especially if export constitutes an important aspect of the affected economy (Van Rijnekeghem, 1999: 4-5). Furthermore, a financial crisis may cause a country to devalue its currency, thus hurting the competitiveness of surrounding countries, which see their export demand fall, and may need to devalue their own currency in order to maintain their market position in third countries (Ib: 5). Using a large dataset, Glick and Rose (1999) show that trade does indeed provide an explanation of financial crises through devaluation, which is why so many currency crises are regional. Devaluing the exchange rate in order to gain competiviness compared to your trading partners is called competitive devaluation, and has been called one of the possible causes of the Asian Financial Crisis (Corsetti ea, 1998: 1). For the 2007 global financial crisis, Rose and Spiegel (2009) argue that the having the United States as the originator of the crisis doesn’t mean that American
competiveness in emerging markets has improved, but rather that those countries experienced a decline in exports to the US (2009: 6), which then led to the aforementioned fall in demand and deceleration of growth.
Contagion: the financial channel
While trade may be the most ‘visible’ of the economic connections between countries, financial linkages may be just as important in explaining why and how currency crises spread. The most direct way occurs when financial institutions from the crisis centre have large holdings abroad that may go bust (Fratzscher, 2003: 7). Assets with international exposure then have an adverse effect on a country’s balance sheet. This was especially true for the 2007 crisis, which was preceeded by a decade of financial innovation. New financial products, which turned out to be especially vulnerable during a crisis, were widespread internationally (Rose and Spiegel, 2009: 7).
The financial channel can also work indirectly. Banks that have sustained losses in a crisis may not extend their lending towards emerging markets. Groups of
countries that have a common creditor are especially vulnerable to this phenomenon. This creditor might not just stop providing credit and call back loans in the country that originated a crisis, but also call back loans elsewhere in the region in order to mitigate losses. In trying to save itself, such a common creditor is perpetuating and even spreading the crisis to other countries (Kaminsky and Reinhart, 2000: 149). This may explain at least a part of the rapid contagion in the Asian Financial Crisis,
because most of the affected countries had extensive creditlines with Japanese banks and those dried up very rapidly (Ib). The reaction from a single common creditor causing a crisis can be extended to a group of heavily interconnected banks, where the losses and default of one may have repercussions for its interdependent banks abroad, which then extend this problem further to this banks’ partners (Cheung ea, 2009: 5). The result of the credit stop is the same in this case, but its effects are exponentially larger.
It can be hard to distinguish between the financial channel and the trade
channel, because most countries that are heavily linked in trade tend to also be linked financially (Kaminsky and Reinhart, 2000: 147). The common creditor problem plays out via the financial channel, but has sincere repercussions on trade of the affected countries, which may then infect other countries in the region via the trade channel and so on.
It should also be noted that while the decreased credit lines and calling back of loans are an important transmission system, it isn’t the only mechanism of the finacial channel. Because most financial systems nowadays are market-based, shocks may also be transmitted through the repricing of risks and subsequent price changes. Thus, a shock may have a considerable adverse affect on a country’s balance sheet (Cheung ea, 2009: 5).
Contagion: asymmetrical informartion and herding behavior
The transmission channels highlighted above explain how a crisis may spread from one country to the next, but in order to fully explain why financial contagion can spread among a region that quickly, we need to look at the behaviour of investors and creditors. Ideally each investing or crediting institution would collect their own information, and set their own expectations and actions accordingly. In reality
however, information is often incomplete and asymmetrical (Ib. 2). Because collecting detailed information is costly, it is often done by just a few actors in the market. Therefore, when a few large speculators acquire some new information, it is possible for the entire market to act on this, leading to large current account reversals. This phenomenon, where investors and speculators base their (often incomplete) information on just a few actors is called ‘herding behavior’ (Fratzscher, 1998: 668). Herding may explain how crises can be exacerbated by the following mechanisms:
‘Wake-up call’ contagion occurs when a crisis in one country provides new information to investors and creditors that may serve as an inducement to reassess the riskiness of assets in other countries, and finding that they have similar weaknesses (Goldstein, 1998: 18). A good example of this is the beginning of the global financial crisis: when housing prices fell and it was discovered that there were a lot of bad loans hidden on banks’ balance sheets, it led to the riskiness of all these assets being reassessed, prompting the (near-) collapse of a lot of banks and financial institutions worldwide. Goldstein (1998) uses the ‘wake-up call’ hypothesis to explain why the Asian Financial crisis spread quite so rapidly from its initial source, Thailand, to other economies.
‘Pure’ contagion (drawn from Giordano ea, 2013: 8) refers to those types of financial contagion that have no basis in the fundamentals of the affected economies at all: they come from essentially irrational (or panicky) behavior. An example of this phenomenon is when trouble in one country may cause investors to abandon an entire region. Widespread loss of confidence is a self-fulfilling prophecy and when combined with irrational herding may lead to an otherwise healthy country to be thrown into a crisis.
Summarizing, there are three types of financial crises that can hit emerging market economies: a government debt crisis, a currency crisis and a banking crisis. The latter two often occur simultaneously, such as in Indonesia during the Asian financial crisis of 1997 (Kaminsky and Reinhart, 1999: 14). The 2008 Global Financial Crisis took the form of a severe banking crisis in many developed countries. In emerging markets there was also the danger of a currency crisis, with many Asian currencies
financial contagion can hit all countries alike, emerging markets have been getting their unfair share of contagion, whether rational or irrational, becase the risk of herding and largescale capital flight is a lot bigger there. After this short analysis it is possible to identify the most important macroeconomic fundamentals that either cause a financial crisis or cause it to be contaminated by a crisis in another country. It also possible to identify certain policies that might mitigate the negative effects before and during a financial crisis.
Macroeconomic Fundamentals
The second hypothesis of why emerging markets fared so much better during the global financial crisis compared to earlier crises was that its macroeconomic
fundamentals had much improved in the last few decades. Its economic outlook meant that the shock which traveled from the US mortgage market all over the world wasn’t able to hit emerging markets as hard as they had during previous crisis. In this section I will outline what these fundamentals are specifically, drawing on the preceding analysis of financial crises and their contagion.
The exchange rate
There has been a large amount of debate over which exchange rate regime makes a country more volatile. Having a fixed exchange rate is a good way for the government to control inflation, which is often a problem in emerging markets (Mishkin, 1999: 722). Countries operating with a fixed exchange rate system are much more susceptible to a speculative attack, though, especially when the government is
committed toward defending the currency until being forced to depreciate (Krugman, 1979). Whether the country should float its exchange rate during a crisis depends for a large part on the size of the balance-sheet effects it is trying to prevent from
happening (Ib.). Countries with a high exchange rate appreciation are more likely to maintain that policy, because of the economic shock the sudden devaluation will give When capital inflows become capital outflows, the devaluation will be larger the higher the previous appreciation was. In case new information hits the market,
investors will be more likely to pull out of the countries with the highest appreciation, ie those where possible losses are biggest (Sachs ea, 1996: 2). Econometric evidence of whether fixed exchange rates actually make for a country experiencing a worse crisis is mixed at best (Blanchard ea, 2010: 276). The exchange rate and the economic reality being mismatched is the greatest danger, especially when combined with a government willing to defend the peg until the last possible moment.
Level of foreign exchange reserves
Having a low level of foreign exchange reserves means that a country is not able to defend itself against devaluatory pressure. Domestic and foreign investors will want
the aforementioned speculative attacks wherein speculators will actively try to deplete the country’s reserves for their own gain. Having an adequate and diversified amount of reserves helps a central bank prevent and financial crisis and avoid contagion. Specifically, having an adequate reserves to short term external debt ratio is important (Kunzel ea, 2009) as is a healthy m2 money to reserves ratio. In addition to
preventing speculative effects it serves as a buffer to capital outflow.
Level of external debt
Blanchard ea (2010: 292) find that of all variables that explain how hard a crisis affects an emerging economy short-term foreign debt (both banking and nonbanking) is the most consistent and significant. Part of the reason is that these can be called in short-term, which particularly in a period of financial turmoil has farreaching effects. Creditors are often unwilling to roll over short-term debt when there's doubt, be it rational or irrational, about the borrowers' ability to pay. In combination with a floating exchange rate and in a denomination of the domestic currency, the debt burden gets exponentially larger, especially during a time when banks and financial institutions cannot sustain such shocks. Iceland in 2008 is a particularly potent example of this, wherein the fall of its most important banks eventually led to the entire country defaulting.
Government Debt
High levels of government debt relative to GDP don't necessarily have to be a
problem, seeing as many developed countries also have high ratios. Emerging markets however default on their debt a lot more often than developed countries. Creditors are more than happy to borrow to emerging countries as long as they look like profitable investment opportunites, but when trouble looms they also call in those loans in a lot more quickly and refuse to roll them over. Particularly Latin American countries have traditionaly had problems keeping their levels of government debt under control, which was one of the root causes of the Latin American debt crisis of the 1980s. It was still a big issue in 1994 when Mexico defaulted on its loans, and Brazil and Argentina also got into trouble.
Policy Options
The previous sections served to illustrate the two main ways in which an emerging economy can be affected by a financial crisis. Weak macroeconomic fundamentals can cause a financial shock to turn into a fullblown crisis, because they expose certain basic deficiencies in its institutional framework. But that’s not the only way a for a country to become infected. Heavy trade or financial linkages with other infected economies may cause a crisis to transfer across borders. This crisis may be
completely based on economic realities, but may also be caused by market sentiment, group think and self-fulfilling macroeconomic mechanisms, particularly in countries that have large amounts of foreign short-term debt.
The third hypothesis of why emerging market economies did better during the global financial crisis than during previous crisis is that they implemented 'better' policy before and during the crisis. This requires the definition of a set of ‘better policies’ that serve to mitigate a crisis. The focus lies on policies that have proven to make an economy less vulnerable via the funadamentals and contagion channel. By staying as close to the theoretical underpinnings as possible, the policies presented are as close to generalizable as possible, but it should be recognized that full objectivity in these matters is impossible.
Monetary Policy
The primary goal of most central banks is price stability, represented by a low positive inflation target, for instance at 2%. This ensures a general confidence in the currency. The normal advice is that interest rates simply follow the level prescribed by the desired inflation target. However, a few caveats are in order. Extremely low interest rates may cause investors to ‘search for yield’, ie more lucrative investments, like for instance the mortgage market in the run-up to the 2008 financial crisis (Portes, 2014: 49). In order to prevent a crisis, a boom should be used to build up buffers for the inevitable crisis, which is technically inconsistent with the normal inflation targeting objective (Ib. 53). During a crisis a central bank should provide liquidity in order to prevent bank runs. The reserves of a central bank are not there for normal times, but to be used extensively during times of crisis to shore up confidence and calm the market down.
Raising interest rates in order to protect a fixed exchange rate was thought to be the wiser decision in financial crises. Raising interest rates and concurrent liquidity squeezes may help keep inflation under control, but at the same time it increases financial panic. Furthermore, it puts previously solvent firms in danger of default, because of the contraction in liquidity. Ortiz ea (2007) provide econometric evidence that monetary tightening led to a significant increase in output during the Asian Financial Crisis. When evaluating the monetary policy that Indonesia and Brazil implemented, I will therefore look whether the monetary policy is tight or loose. Also the effect of liquidity is important. Ideally, a central bank should inject liquidity into the appropriate places in the economy. This constitutes a counter-cyclical monetary policy
Fiscal Policy
Fiscal policy during financial crises should just like monetary policy be
countercyclical. Conventional policy is fiscal tightening during times of economic distress. However, recent macroeconomic theory suggests that crises are the time for the government to invest in the economy, usually in the form of an economic stimulus plan. This can be in the form of a cut in income tax, by subsidizing certain kinds of investment, or by just plain grants. There is one big caveat though. The government must be in a surplus to have the budget to be able to spend any money at all. Seeing as during captial flight international credits are hard if not impossible to come by, the government or central bank must commit to building buffers early, even if that goes against conventional economic wisdom.
In both crises in both countries I will evaluate whether fiscal policy is tight or counter-cyclical and what effect that had on the economy. In the case of a fiscal stimulus plan, I will see what it entailed and what sections of the economy it helped.
The banking system
A weak banking system can start off a crisis, worsen it and is a primary source of contagion across regions. Therefore, an economy needs to have a sound and stable banking sector if it wishes to prevent and better deal with financial shocks. For banks, this would mean they would have to be sound financial institutions that invoke a sense of trust even in the worst of times. It also means that they’re better regulated. Capital requirements, and especially those that have risk-based surcharges, limit the
stress on individual institutions and make contagion less likely (Favara and
Ratnovski, 2014: 139-140). Because there always is an incentive for bankers to lend as much and as profitably as possible, sometimes lending limits and restriction of certain banking activities may be necessary (Ib.). It should be obvious that the soundness of the banking system is one of the key components of succesful dealing with crisis and contagion. It is important both as a macroeconomic fundamental and as a source of contagion. Therefore, I will in both case studies present a section on the state of its banking system.
Research Design
The main question of the thesis is How and why were the so long crisisprone emerging market economies able to avoid being a central part of the problem and origin of the global financial crisis of 2007-09? In this section I will outline my research design, and explain what methodological choices and considerations I made.
My research is predicated on three hypothetical answers to the main question: Emerging market economies were largely decoupled from the crisis. Emerging market economies fared better, because the country's
macro-economic fundamentals were better.
Emerging market economies had better policy before and during the crisis.
All hypotheses probably have some degree of truth in them, in other words I consider it unlikely that policy for instance had no influence at all on the severity of the crisis. The question then becomes which of these hypotheses has the most explanatory power. The dependent variable is the severity of the crisis, with the size of the shock, the macroeconomic fundamentals, and policy as the independent variables. This would make the implied 'equation' something like this:
Severity crisis = α size shock + β fundamentals + γ policy
The alpha, beta and gamma are the magnitudes of each of the independent variable's impact on the severity. This is of course a highly simplified version of reality, but it does clarify my intent.
A case study
The most obvious way of going about researching this is conducting large-n research, where you try to parameterize each of the independents and then do a regression of some kind. The problem is that that would require the quantification of the process of policy, which include many institutional factors as well. While not impossible, it is highly involved and the results would be likely be contentious at best. That's why I have chosen for qualitative research in the form of a case study of two emerging
markets over time. The advantage of a case study in this case is that I can collect a wide range of variables over time, which will give me a full overview of a single case (Bulgram ea, 2008: 66). Case studies are especially succesful when it comes to collecting context-specific data. Policy measures are specific to the institutional framework in which they are made; the same monetary policy can produce vastly different results when taken in another country with different institutions. By being context-specific, it will be easier to outline in detail the causal effects of a specific policy in a country with different macro-economic fundamentals and vice versa. That's why I've chosen to have a temporal rather than a spatial comparison. By comparing the state of a country before a crisis at the end of the 1990s and before the financial crisis of 2009, I'm able to take into account the institutional changes in the time between the two much more than when I would've compared two different countries.
Case Selection
I've chosen for two cases: Indonesia and Brazil. Indonesia was severly affected by the Asian financial crisis of 1997, which started in Thailand. Brazil has experienced many crises in last few decades, but the focus here will be on the concurrent banking and currency crisis from 1995 that originated in Mexico. Both countries were hit by the 2008 financial crisis, which did made 2009 a year of economic downturn. However, they were not as severely hit as during their respective previous crises. The thesis is primarily concerned with financial crises as a result of sudden stop problems of outside capital: ie, financial contagion effects. That's primarily why I picked Indonesia. In 1997 it was the prime example of a country that got seemingly
disproportianally affected by an outside crisis. In 2009 it was hardly affected at all. To find out why, we need to compare the two crises. However, in order to give a
satisfactory answer what accounts for the change across many emerging markets, a comparison with another emerging country's experience is necessary; a comparison of historical comparisons so to speak.
Peters (1998: 31) notes that in order to compare two cases they need to "maximise experimental variance, minimise error variance, and control extraneous variance." Comparing Brazil and Indonesia covers for all three:
One characteristic of the Indonesian economy is that it is not as reliant on exports as other countries in the region. Basri (2013) argues that this is firstly because Indonesia exports a lot of primary goods to China and India, whose demand stayed largely intact. Secondly, he notes that exports does not represent as important a part to the Indonesian economy as it does to other countries in the region. The effects of the decline in trade during the global financial crisis is well documented and overall in line with classic theory, so I don't consider the selection of Indonesia as being a handicap. In order for the analysis to be meaningful, a comparison with a country where exports did similarly did not play as much of a role during the global financial crisis is necessary. This is the case with Brazil. Brazil wasn’t as dependent on exports as other countries in the region, with their exports accounting for only about 13% of total GDP
(Toshniwal, 2012: 216). Thus, while those were hit hard, it had only a relatively small impact on the economy. By comparing Indonesia and Brazil, I control for extraneous variance to minimize the effect that a difference in trade levels would give. As such, the implications of the research might only be applicable to emerging countries that are not as dependent on international trade, even though the overall message about fundamentals and policy stays roughly the same.
The experiences during the global financial crisis were roughly the same in Indonesia and Brazil. Their experiences in the nineties however were very different. Brazil's problems stemmed mostly from managing public debt and fiscal prudence, that culminated in the financial crisis of 1995. Indonesia's problems were more on the monetary side of the economy. It was also
overleveraged to a vast degree. I maximise economic variance by picking two countries that had very different economic problems and trying to find common features in their experience.
Comparing Indonesia and Brazil aminimises error variance, meaning that neither of them is an exception. Their experiences during the crises of the nineties were roughly indicative of their respective regions. Similarly, their good performance during the global financial crisis was a trend across almost all emerging economies.
Variables
In the previous theoretical sections I've identified several macroeconomic variables that are indicators of an economy being vulnerable to financial crisis, either for within or external. In the case studies I've collected data for the years leading up to the financial crisis in the nineties and the global one.
The first set of indicators is a set that I will call the indicators that show the general economic outlook. They show the overall economic health of the country and might explain a crisis originating in a country or creditors getting nervous about it when other countries in the region fall, thus leading to financial contagion.
o GDP growth in %
o Current Account As Percent of GDP o Inflation (consumer prices, annual %)
The second set of indicators have more to do with a country being vulnerable to sudden stop problems and financial contagion:
o the exchange rate regime
o government debt to GDP in % / gross debt as % of GDP o external debt stocks (% of GNI)
o short-term debt (% of total external debt) o total foreign exchange reserves
o M2: money and quasi-money to total reserves ratio o short-term debt (% of total reserves)
The data from these indicators comes from World Bank, IMF, and Bank of
International Settlements statistics. Where possible, I've graphed the years leading into the both crises in one line plot or table, with t = 0 representing the 1995 / 1997 in the earlier crises of respectively Brazil / Indonesia, t = 0 representing 2009 in both cases.
The data on policy measures are organised as follows: o Monetary Policy
Data from this section comes from the Indonesian and Brazilian national banks and statistics offices, and from relevant scientific literature from economists / political scientists in the country. In this way, Basri and Siregar (2009) was incredibly useful for Indonesian policy and Toshniwal (2012) for Brazilian policy. At the end of each subsection I will classify the policy in a few words, so that I'm able to compare them in the analysis.
Indonesia
Introduction
Indonesia has suffered two major financial crises in the last twenty years: the East Asian Financial Crisis of 1998 and the global financial crisis of 2008/09. Neither crisis started in Indonesia, but both profoundly impacted its economy.
The direct cause of the 1998 East Asian financial crisis of is debatable. Large companies in Korea, such as Hanbo Steel, began defaulting on their debts in early 1997. At the same time, there were concerns about the sustainability of the Thai economy which was increasingly relying on a large amount of short-term foreign debt. The decline of the stockmarket and the collapse of several of its major companies and banks, led to increasingly unsustainable pressure on the Thai baht, which was a fixed currency at the time. On 2 July 1997, the baht was forced to devalue, plunging Thailand into deep recession (Radelet and Sachs, 1998: 27). Investors and foreign banks then started worrying about similar countries throughout the region, like the Philippines, Malaysia and Indonesia. These countries all had fixed exchange rates and relied heavily on short-term lending (Ib. 24-25). Capital began flowing out of the region, and many currencies were forced to devalue. Indonesia was one of the many victims of speculative attacks in the region. The exchange rate of the rupiah was forced to float its on 14 August 1997, plunging Indonesia into a deep crisis. GDP growth to fall from 4.7% in 1997 to -13.1% the following year (Figure 2). This massive drop quickly carried over to the real economy, with the national poverty rate rising from 15.7% to 27.1% from February 1996 until February 1999 (Pradhan ea, 2000: 18). The ensuing social changes were what led to the toppling of the
Soeharto political regime that had been in place for 32 years. It ended up taking years for the Indonesian economy to fully recover.
A decade later, in 2008, Indonesia faced the Global Financial Crisis, which affected almost every country worldwide and certainly had the potential to be just as devastating to the Indonesian economy as the 1998 crisis. Indeed, Indonesia’s overall economic growth slowed and the stock market, which is often an indicator of the real economy, took a tumble. Still, while the Indonesian economy experienced a slump, it was not nearly of the same level as the 1998 crisis. This is especially obvious when you look at the graph of GDP growth on the previous page. Compared to the
Figure 2: Real Indonesian GDP growth in % Source: World Economic Outlook & IMF datamapper
swandive that the Indonesian economy took in 1997, the 2008 one looks like a mere hiccup. The crisis also didn’t nearly have the same social and political implications as the 1998 one had. This section comes in two, the first part representing the
fundamentals hypothesis and the second part focusing on policy.
-16 -14 -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Indonesia and its macroeconomic fundamentals
One of the hypotheses of why Indonesia was not affected as much during the Global Financial Crisis of 2008/09 than during the 1998 Asian Financial Crisis is that its macroeconomic fundamentals had become a lot stronger. Better macroeconomic fundamentals means two things. First, an external shock doesn’t expose deficiencies in the domestic economy, making speculation and a sudden stop in credits less likely. Secondly, it protects Indonesia from contagion by neighbouring countries. In the theoretical sections I have outlined what some of the most important fundamentals are. In this section I shall compare the two at the onset of both of Indonesia’s crises.
Overall economic health: GDP growth, current account and inflation
First, I shall compare some of the general economic macro-economic indicators before both crises. In the following graphs the years before and a few years after both crises have been highlighted, with the t = 0 being 1998 in the East Asian crisis and 2009 in the global financial crisis. I've chosen for the year 2009 since the effects of the global financial downturn began to be truly felt in that year, with international exports and global demand being down.
Figure 3: GDP growth in % Source: World Economic Outlook, Worldbank
Comparing the drop in GDP growth, the first thing to notice is that the 1998 crisis was much more severe, with GDP growth dropping (nay, collapsing) from 4.7% in 1997 to -13.1% in 1998. What's also important to see is that there were no real signs of the economy slowing down in the years before either crisis. The growth rates were very high before the crisis, and have never quite returned to that level, with 1995's 8.2% growth being the absolute maximum.
Figure 4: Current Account as percent of GDP Source: World Economic Outlook, Worldbank The difference between the impact that the 1998 and 2008 crisis had on Indonesia can also clearly be seen in figure 4. With the floating of the exchange rate in 1998, the current account deficit became a surplus, and has remained in surplus almost ever since. The current account deficit prior to the Asian crisis was financed by large amounts of short-term foreign debt, which pulled out after the economic climate of Indonesia became toxic (Iriana and Sjoholm, 2002: 144). During the 2008 crisis, the current account deficit widened due to a contraction in both imports and exports, pointing to a decrease in investment (Basri and Siregar, 2009: 14), but quickly went back to its prior values. It should also be noted that in the years prior to the Asian Financial Crisis the current account deficit had been relatively stable and low
compared to other countries in the region, where a deficit of more than 5% was not uncommon. Considering this fact, the instance and severity of the 1998 crisis in Indonesia can be seen as surprising.
The shock to the financial account during the 1998 crisis was also much larger than that of the 2008 crisis. The financial accounts ratio to GDP dropped from over 5% in 1996 to near-30% in 1998, a drop of 35%. In 2008 this drop was only 6% to -5% of GDP (Hadiwibowo, 2009: 17).
Figure 5: Inflation (consumer prices, annual %) Source: World Economic Outlook, Worldbank It should be clear which line represents inflation during the Asian financial crisis. In 1998, at the height of the crisis, inflation rose to a record 58%. The massive inflation translated itself in rising food prices, which was one of the main causes of the
increased poverty during the Asian Financial Crisis (Basri, 2013: 10). Inflation prior to the 1998 crisis had been low, always remaining in the single digits. This was true for almost all countries in the region that got caught up in the 1998 crisis (Corsetti ea, 1999: 19). Inflation before the 2008 crisis was in fact more volatile and at times higher, even though the central bank of Indonesia adopted inflation targeting as strategy in 2005. Even though there was no increase in inflation during the 2008 crisis, constant changes in inflation expectation made it harder to implement monetary policy, as I will show in upcoming sections.
Exchange Rate Regime
One of the major differences between the different crises was the different exchange rate regime. Before the crisis, Indonesia had a managed fixed exchange rate regime. A spectacular speculative attack made the currency peg untenable and Indonesia was forced to devalue. I won’t have to point out the exact moment in the graph below.
Figure 6: Rupiah Real Exchange Rate Source: Bank of International Settlements Data Before the crisis hit, the exchange rate had slowly but steadily appreciated in real terms, because the capital inflows put upward pressure on capital inflows. In the case of Indonesia this appreciation amounted to more than 25% between 1990 and the crisis (Radelet and Sachs, 1998: 24). Economic downturn is made all the more costly if the real exchange rate is overappreciated. As such, it is one of the main indicators of a pending currency crisis; if investors and speculators sense the currency is
overvalued they will want to exit the country pronto to cut their losses (capital flight). The devaluation was especially costly because large amounts of the debts were US dollar-denominated. This meant that when the currency suddenly depreciated these loans were suddenly a lot more costly, especially for companies that traded in Rupiah, but borrowed in US dollars (Basri, 2009: 24). The downturn of the economy
spurred itself this way. Companies also find it harder to borrow abroad under these circumstances, just at a time when they might need it most (Ib).
The situation was more stable in 2007. As is obvious from figure 6, the rupiah was forced to devaluate again. However, this time the currency was not
overappreciated, and because of that the effects played out a little less dramatically than they had done during the previous crisis. The fall of the exchange rate had come as a complete shock in 1997 and made economic actors even more panicky than they already were. In 2008 the reaction was different: actors were now used to working under a fixed exchange rate and knew better how to diversify their risks (Basri, 2013: 10). Also, because they had let go of the pegging to the US dollar, the government was not committed to defend its currency too much.
Even though its results were less devastating this time around, the devaluation still had a negative effect on the economy, albeit a lot better than in 1997. One more point deserves to be made in this context. When a currency normally devaluates, it naturally means that the country’s products are relatively cheap for foreigners, and as such there’s a rise in exports. However, because financial crises tend to play out regionally, and in the case of 2008 even globally, this ‘sterilization effect’ didn’t happen. Demand for exports still dropped (Ib: 6).
Government budget
Figure 7: Fiscal Balance Indonesia Source: Basri and Hill, 2011: 93
Figure 8: Central government debt to GDP (in %) Source: World Economic Outlook, Worldbank Indonesia has always been a fiscally reasonably sound country, even prior to the 1998 Asian Financial Crisis. Even though the government funded many infrastructure projects, often executed by the family and friends of President Suharto, its fiscal balance managed to always remain on the close-to-0% side. The Indonesian government's commitment to maintain a prudent fiscal stance can also be seen in figure 8. Indonesian government debt in the run-up to 1998 was at a healthy +/- 35% degree, which is modest for a developing country. The financial crisis prompted debt-to-GDP to go way up, mainly because the depreciation of the rupiah had adverse effects on its debt burden. Ever since this meltdown, the government has committed to keeping this ratio under control, which caused to slide continuously since 2005. The global financial crisis had almost no effect on its fiscal stance.
Foreign debt
One of the primary factors of the Indonesian economy that caused trouble before the onset of the Asian financial crisis was the rapid inflow of capital into the economy. Foreign financing was easily attainable, especially in the form of foreign bank loans (Radelet, 2000: 3). These capital inflows equaled about 4% of GDP, which was still pretty low for the region (Ib). Relaxed laws on using foreign capital caused banks to borrow abroad and then invested it domestically, with outside investors feeling good
about the then booming South-East Asian countries. Large amounts of loans don’t have to be a problem, but dependence on short-term foreign capital can be dangerous.
1993 1994 1995 1996 1997 1998 1999
58,70% 62,60% 63,40% 58,30% 65,10% 168,20% 117,40%
2005 2006 2007 2008 2009 2010 2011
52,10% 39,00% 35,70% 32,10% 34,50% 28,80% 26,70%
Table 1: External debt stocks (% of GNI) Source: World Development Indicators, World Bank
1993 1994 1995 1996 1997 1998 1999
20,20% 18,00% 20,90% 25,00% 24,10% 13,30% 13,20%
2005 2006 2007 2008 2009 2010 2011
7,80% 9,00% 12,60% 13,00% 13,40% 16,70% 17,40%
Table 2: Short-term debt (% of total external debt) Source: World Development Indicators, World Bank
The total amount of outstanding external debt prior to the 1998 crisis was very high for the region (Corsetti ea, 1999: 335). During the Asian Crisis it even rose to a staggering 168,2%, due to the falling national income and the fact that many loans were dollar-denominated. The share of short-term debt to total external debt rose to about a quarter during this period. Large amounts of short-term debt however makes a country especially vulnerable to a sudden stop and capital reversal (Calvo and
Reinhart, 1999: 2). Overconfidence from both foreign investors and domestic banks created a lethal combination.
The situation was different in 2008. In previous years, the total amount of outstanding debt to GNI has gone down, which translated itself in there being almost no spike during the 2008 crisis. Also, the ratio of short-term to total external debt had gone down significantly. In fact, it was one of the lowest countries in the world when it comes to this (Basri, 2009: 17). Short-term foreign lending is still an important source of finance in Indonesia, but its composition has changed compared to the pre-Asian crisis situation. Most are revolving loans and about 35% of the private loans is
of loans considered long-term that were due in three years, so had the crisis lasted longer, Indonesia would’ve faced the same problems a little later. When the financial crisis hit, there was not as much danger for sudden outflow of capital.
Foreign Exchange Reserves
As established, countries are especially liable to speculative attacks, if they a) are willing to defend a currency peg and b) have too little foreign exchange reserves to do it with. As such, a country is better off having a large foreign exchange stock before the crisis, because it will cause speculators to look elsewhere. In figure 9 is the development of the total foreign exchange reserves during the last few decades1.
Figure 9: Total foreign exchange reserves. Source: World Economic Outlook, Worldbank I'd almost let that graph speak for itself, but it is not only the total amount of reserves that counts, but especially their ratio to other key variables. Sachs ea (1996: 3) consider the ratio of M2 money to foreign exchange reserves, because M2 money represents the money that speculators can convert into foreign currency.
1 I have used World Bank Data for foreign reserve tables, which included gold holdings. Gold holdings tend to be by their very nature very illiquid, and as such can't serve as a shield against speculative attacks and devaluation. Indonesia's total gold only amounts to 2,7% of total reserves (International Financial Statistics), which I thought negligable enough to ignore.
Figure 10: Money and quasi money (M2) to total reserves ratio
Source: World Economic Outlook, Worldbank
A high ratio means more danger for this switching into foreign exchange. The ratio before the Asian Financial Crisis can be seen as dangerously high. The reserves were then quickly depleted during the crisis. Once again, the 2008 crisis shows that the ratio was considerably lower, making Indonesia less of a target for speculators and rapid devaluation. The graph in figure 10 shows connects two of the most important concepts when it comes to being contaminated in a financial crisis: short-term debts and foreign exchange reserves.
It is clear that the short-term debt to total reserve ratio is considerably higher before, during and even after the Asian Financial Crisis. This means that the amount of potential outflow is not in any way covered by foreign exchange reserves, making any attempt by the government to defend the currency futile in advance. It also serves as an indicator that the entire economy is in way too much in debt.
The results when it comes to the macro-economic fundamentals are mixed. The 'common' indicators of GDP growth, developments in the current account and levels of inflation didn't provide any indication that the Asian Financial Crisis would affect Indonesia quite as much as it did, and as such aren't fundamentals that precede a crisis in which international contagion is a factor. The composition and maturity of loans are likely a factor as both theory and data would suggest, as is the foreign exchange levels. Concerning the exchange rate regime, there is a lot of debate whether a fixed or floating regime makes an economy more susceptible to crises. In Indonesia it's likely that switching to a floating regime was for the better, but a lot of it depends on the governments handling of the exchange rate.
Indonesia and policy in response to financial crises
The second theory of why Indonesia was less affected by the 2008 crisis than the 1998 crisis is that its government’s policy both before and during the crisis was much better in 2008. In this section follows an overview of Indonesian policy responses during the 1998 and 2008 crises.
The Asian Financial Crisis started with the floating of the Thai baht in the beginning of July 1997, putting pressure on the Malaysian, the Philippine and the Indonesian currencies. As a precaution against overheating, the central bank of Indonesia had already been widening the band within which the rupiah could float from 8% to 12%. This was by far not enough as international credit drew out of Indonesia rapidly. The Bank had to let go of the peg entirely on 14th August 1997 (World Bank, 1998: 3-4). Even though floating the Rupiah had been discussed before as a solution to the unsterilized capital inflows, it caught the market completely unaware. Companies had been borrowing in US dollars and spending in Rupiah based on the peg, and their debt burden rose exponentially. Bank Indonesia had not been aware of the extent of short-term foreign-denominated debt, which made them seem to have a less than firm grasp on the economic situation (Sherlock, 1998). As
uncertainty grew and investers withdrew, the rupiah continued to spiral down, almost gaining speed as it went to a record 109.6% drop in December 1997 (World Bank, 1998: 4). The crisis was complete. While the central bank during all this did their best to shore up the economy, it couldn’t halt the relentless downturn. In October 1997, president Soeharto sought help of the IMF and the World Bank, originally only to seek a small unconditional emergency loan (Sherlock, 1998). As Indonesia’s
problems grew more severe however, it turned into a 37 billion US dollars loan (IMF, 2009). Attached to these were conditions of restructuring the economy by cutting government spending, monetary tightening, deregulation and the restriction of bailing out troubled banks. Arguably, this made the financial panic even bigger, while the rupiah continued to drop (Riesenhuber, 2001: 194-196). As the financial problems made their way into the real economy in the form of rising poverty and debt, political instability grew, culminating in the end of Suharto’s 31-year New Order regime. Indonesia only started moderately recovering in the early aughts, with the IMF support formally suspended in 2003.
Indonesia’s response to the 2008 global financial crisis can almost be seen as a reaction to the mistakes made a decade earlier. Bank Indonesia became an
independent national bank in 1999 and became an inflation targeter in 2005. During the 2008 crisis focused mainly on maintaining confidence in the banking system in order to prevent the self-fulfilling low expectations of the economy (Basri, 2013: 12). The main focus lay on closely watching developments in the financial markets and providing injections where necessary, making sure that international panic didn’t infect the Indonesian economy to a large extent. In the next paragraphs I will categorically highlight the difference in policy between the two crises.
Monetary Policy
1998 Asian Financial Crisis
The government from the onset followed conventional economic wisdom. In order to keep the currency from depreciating, the Bank Indonesia kept raising interest rates in order to slow down depreciation. In August and September of 1997 the short-term interest rates got as high as 57.5%, which combined with 13.1% inflation gives a 44.4% real interest rate (Weber, 1998: 12). However, this also kills off investment, which is already not in the best position, and forces firms who are in dire need of credit to default on their loans and in bankruptcy (Ib.). The policy thus constituted a liquidity squeeze, right at the moment that more liquidity was needed to keep firms and especially banks afloat. The tightening of liquidity also heightened financial panic about the heavily in debt financial sector (Riesenhuber, 2001: 176).
When the IMF came in at the end of 1997, it continued the tight monetary stance. It set an inflation target of 20% at the end of 1998 (Weber, 1998: 10). Interest rates were kept high. This further created financial losses and debt repayment
problems for otherwise healthy companies (Corsetti ea, 1998 :16). The increased risk of default thus caused capital outflows (Basri, 2013: 10). The IMF has subsequently been criticized of holding on to tight monetary policy.
Characteristics: Tight monetary policy, liquidity squeeze
2008 Global Financial Crisis
“In the Board of Governors’ Meeting convened today, Bank Indonesia decided to reduce the BI Rate by 50 bps to 8.75%. This decision was taken after a comprehensive evaluation of the current domestic and international economic and monetary
conditions and the outlook for 2009.
Bank Indonesia Press Release, 7 January 2009
The response of Indonesia’s central bank to the 2008 financial crisis is almost the polar opposite to that of 1998. This time the central bank decided to lower interest rates instead of raising them (figure 3). The press release above is just one example of
Figure 12: BI policy rate in percent Source: Bank Indonesia, 2015 the central bank pre-emptively lowering interest rates, specifically citing the turmoil in the international markets. In total, the central bank ended up cutting the policy rate more than 300 percent points from the end of 2008 until the end of 2009, and didn’t raise them again until 2012 (Bank of Indonesia ). It had the space to do this, because consumer prices kept relatively stable during this period, which is necessary to maintain consumption growth (Tambunan, 2010: 164). This lowered the probability of firms not being able to make payments and defaulting on their loans. This shielded the real economy from the trouble in the financial markets (Basri, 2013: 11) and prevented massive capital flight.
“The impacts of global economic and financial fluctuations have the potential to undermine bank liquidity in both rupiah and foreign exchange. In order to overcome these impacts and minimize risk that can affect bank system stability, Bank Indonesia considered the need to provide greater liquidity flexibility through, among others, amending the minimum reserve requirement.”
