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

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

4. Indonesia Indonesia 17,500 islands, 200 million people 17,500 islands, 200 million people GDP: US$935 billion GDP: US$935 billion GDP Per Capita: US$3800 GDP Per Capita: US$3800 Unemployment: 12% Unemployment: 12% Population Below Poverty Line: 17.8% Population Below Poverty Line: 17.8%

5. Indonesia: A Brief History 1945: Political instability and a deteriorating economy1945: Political instability and a deteriorating economy 1960s: New Order Administration: inflation comes down, foreign debt becomes manageable, problems begin to arise with oversight and regulation1960s: 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 grows1980s and 1990s: foreign investment increases, GDP grows

6. Indonesia’s Per Capita GDP and GDP Growth Rate

7. 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

8. 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 Y 1 to Y 2 (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.

9. The Asian Financial Crisis Interest Rate Real Real Equilibrium Nominal Nominal Expected Deflation Y=Output LM 0 IS 0 IS 1 Y0Y0Y0Y0 Y1Y1Y1Y1

10. Causes of the Crisis--Domestic Large external deficitsLarge external deficits Inflated property and stock market valueInflated property and stock market value Corrupt governmentCorrupt government High-risk lending--non performance loansHigh-risk lending--non performance loans Wealth concentrated in the hands of a few banksWealth concentrated in the hands of a few banks Pegged exchange ratePegged exchange rate

11. Causes of the Crisis--International The Mexican Peso CrisisThe Mexican Peso Crisis The U.S. Federal Reserve raised interest ratesThe U.S. Federal Reserve raised interest rates Currency speculation in Thailand, Malaysia, and other East Asian countriesCurrency speculation in Thailand, Malaysia, and other East Asian countries

12. Indonesia’s Response to the Crisis: Initial Responses Widened the pegged exchange rate from 8%- 12% Widened the pegged exchange rate from 8%- 12% Raised interest rates Raised interest rates Floated the exchange rate Floated the exchange rate Reduction of government spending Reduction of government spending

13. Indonesia’s Second Response to the Crisis--The Five Point Plan Stabilize the rupiah at a new equilibrium levelStabilize the rupiah at a new equilibrium level Strengthen the fiscal policies and fiscal consolidationStrengthen the fiscal policies and fiscal consolidation Reduce the current account deficitReduce the current account deficit Support the banking sectorSupport the banking sector Reassure the private sector about the stability of the economyReassure the private sector about the stability of the economy

14. IMF’s Response to the Crisis IMF loans to Bank IndonesiaIMF loans to Bank Indonesia An agreement to a balanced budget or surplus, maintain high nominal interest rates and restrict domestic creditAn agreement to a balanced budget or surplus, maintain high nominal interest rates and restrict domestic credit Restructure financial markets Restructure financial markets Adopt good governance reforms and improve oversightAdopt good governance reforms and improve oversight

15. Implementing IMF Reforms Indonesia’s proposed budget included a deficit instead of a surplusIndonesia’s proposed budget included a deficit instead of a surplus IMF claims that Indonesia was not serious about reformIMF claims that Indonesia was not serious about reform Creation of the Indonesian Bank Restructuring AgencyCreation of the Indonesian Bank Restructuring Agency

16. Interpreting Indonesia’s Response Using the IS-LM Model (1)If Y= C(Y-T)+ I(r)+ G+NX(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 IS 2. (4)The Indonesian government continues to artificially increase the interest rates. Thus, they contract the money supply once again (moving to R 2 and BP 2 ) (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.

17. Interpreting Indonesia’s Response Using the IS-LM Model Interest rate Y=GDP LM 2 Interest rate LM 1 LM 0 IS 0 IS 1 IS 2 BP 0 BP 1 BP 2 R 2 R 1 R 0

18. Why the IMF Reforms Failed IMF cannot rally market confidenceIMF cannot rally market confidence IMF publicly announced that Indonesia had deep structural flawsIMF publicly announced that Indonesia had deep structural flaws IMF believed that reducing financial corruption would be enough to reassure creditorsIMF believed that reducing financial corruption would be enough to reassure creditors IMF advocated a contraction to fiscal policyIMF advocated a contraction to fiscal policy Loan packages were not large enoughLoan packages were not large enough Lengthy reform stipulations took up valuable government resourcesLengthy reform stipulations took up valuable government resources Initial loan programs and agreements were not made publicInitial loan programs and agreements were not made public

19. Indonesia Post-Crisis Democrat election of Susilo Bambang YudhoyonoDemocrat election of Susilo Bambang Yudhoyono Focus on improving access to basic necessitiesFocus on improving access to basic necessities Reduction of government’s debt ratioReduction of government’s debt ratio Improved fiscal management and banking systemsImproved fiscal management and banking systems

20. Potential Future Steps 1. Continue to improve the Bank of Indonesia’s transparency, independence, accountability, and credibility 2.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 3.Increase tax revenue 4.Continue to reduce the debt to GDP ratio

21. Questions?