As with the rest of the ASEAN region, the short and medium term prospects of the Indonesian economy will be affected by the currency crisis and its related wider impact. The market has reacted positively to the news of the IMF package, with the rupiah strengthening as much 10 percent in the first two days after the announcement. However, the full implications are yet to be felt and the rupiah has continued to weaken and the stock market index to drop. While the situation will stabilize in the medium term, it is still difficult to predict when confidence will be fully restored and capital will reflow back, so that the short term economic outlook of the Indonesian economy remains uncertain

1997will be remembered as a year in which Indonesia faced its worst economic crisis since the economic chaos of the 1960s. The cause of the crisis was partly externally generated and pertains to the contagion effect that originated in Thailand and spread to other countries in the region, then also more globally.

The currency movement and to a lesser extent the stock market indexes of the four Southeast Asian countries demonstrate the contagion effect whereby major turning points and trends, mirror each other. All the ASEAN countries have experienced fluctuations in their exchange rates since July 1, amplifying around mid September and continuing to now.

However, apparent weak economic fundamentals, also mark whether the contagion effect precipitates an economic crisis when market confidence begins to be affected. Indonesia as with most of the other ASEAN economies exhibited the signs of weak economic fundamentals as reflected by a more than doubling of the current account deficit from US$ 3.5 billion. to US$ 8.8 billion over the 1994/5 to 1996/7 period. The deficit was in turn financed by a more than doubling of private capital inflows which increased from US$ 5 billion to US$ 12 billion over the 1994/5 to 1995/6 period and was maintained at US$11 billion in the 1996/97.

The worsening of the current account deficit was caused by sluggish export growth especially in 1996 which affected the whole region as a result of a decline in imports from Japan and competitiveness as the yen weakened substantially against the US dollar. The deficit also increased due to the rapid growth in debt servicing, especially to the private sector. The amount of private sector debt (official estimates) in Indonesia more than doubled in three years from US$ 28 billion to US$ 56 billion from March 1994 to March 1996. As long as growth continued and the currency remained stable, the financing of deficit with capital inflows did not pose a problem, and in the case of Indonesia it was always thought that the deficit was still manageable given that it remained a around 4 percent of GDP or half of real growth rate, and lower when compared with Thailand which reached 6 percent of GDP in 1996.

However, as soon as there is a decline in confidence and capital outflows, the size of the deficit matters and the currency begins to depreciate rapidly. The vulnerability is compounded by the percentage of private sector debt that were not hedged due to borrowers reluctance to pay a premium when the rupiah has moved in a predictable way against the dollar for the last ten years at around 3-5 percent depreciation. This implied that the cost differential between domestic and offshore borrowing increased, and the substantial increase in liquidity of low cost offshore borrowing led to less than productive borrowing and investments since the cost does note reflect the true cost of borrowing, including excessive lending to the property sector. The vulnerability of the economy thus also increases with an over exposed and weak financial sector through which much of these funds were channeled.

The basic lesson about ensuring sound economic fundamentals and macro economic policy discipline is clearly demonstrated again. Exchange rates need to be in equilibrium and not be fixed to the US dollar. It also demonstrated that globalization of financial markets and information, imply the need to anticipate shifts quickly and to provide timely and accurate information. Misinformation leads to rumors and misperceptions which affect market expectations.

In the period July-end of October just prior to the IMF package announcement in Indonesia, the baht and rupiah depreciated the most at around 50 percent compared with the other Southeast Asian economies. The "excessive" bout of rapid or 20 percent rupiah depreciation from below Rp. 3000/US$ in mid September to a range of Rp. 3600-3800/US$ up to the time of the IMF package at the end of October, occurred due to a combination of continued strong demand for dollars as companies tried to cover their dollar exposure and a crisis of confidence which goes beyond economic fundamentals since Indonesia's economic fundamentals can be considered better than Thailand. The crisis in confidence is externally as well as internally induced. For instance, the rapid decline in the Ringgit due to statements and actions undertaken by Prime Minister Mahathir and continued concerns about the Thai situation continued to impinge on Indonesia. To make matters worse, the response by the government was seen to be incorrect and insufficient.

The initial response to the floating of the baht on July 1, 1997 was to widen the band of the mid BI rate of intervention from 8 to 12.5 percent on July 11, followed by a free float of the rupiah on August 13, almost a month later. There is some perception that perhaps the float should have occurred earlier. After the float the rupiah immediately depreciated by 6 percent and subsequently went above Rp. 3000, causing the monetary authorities to intervene by a severe reduction of liquidity of several trillion rupiah without releasing it back into the economy through promissory notes as was the case in the last such episode of tightening in 1991. The interest rates of Bank Indonesia certificates were also raised to around 30 percent. As a result the rupiah did stabilize at Rp. 2600-2700, but interest rates soared and there was severe tightening of liquidity. For instance overnight rates shot up to unprecedented highs of 170 percent and deposit rates offered by banks shot up to between 30-40 percent on average.

It has been argued that by targeting a stable exchange rate the cost had been high and if the rupiah had been allowed to float freely, there would have been a one time sharp depreciation with continued fluctuations. This is what happened in the case of the Philippines with the peso depreciating by 13 percent immediately after it was floated in the second week of July, and fluctuating since then, with depreciation of another 14 percent in the September-October period. However intervention to prevent the rupiah from floating by reducing liquidity drastically, meant that the rupiah could not find its new equilibrium and led to a difficult dilemma for the central bank. On the one hand they feared that releasing the liquidity would immediately lead to further weakening of the rupiah as speculators, investors and borrowers exchanged rupiah for dollars. On the other hand businesses and banks could not function under such tight liquidity situation, compounding an already serious cash flow problem for them due to the slowdown in economic activity and demand.

The government approached the dilemma by undertaking some appropriate economic reforms, with the idea that after this was undertaken they could release liquidity as confidence would have been restored by the reforms. First, the government took some steps to reschedule government projects in early September, including announcing the specific projects, and a number of steps to increase non oil exports. The central bank also announced that it is serious about taking strong action to clean up the banking sector, including liquidation of some banks. But they stopped short of announcing the names of the banks. The central bank reduced interest rates but did not release liquidity except very selectively to banks which are healthy but suffered from liquidity problems. The currency hardly reacted to news of the reduction of interest rates.

However, these steps were not seen as sufficient amidst continued external turmoil and a perception that the steps announced by the government were not sufficiently concrete, reflecting lack of political will. This was compounded by a growing sense of uncertainty relating to: the magnitude of the short term private sector indebtedness, exposure due to unhedged loans of the private sector; perceptions that there is not sufficient political will to undertake the reforms necessary; and uncertainty about the political leadership of the country. There are no good estimates of the amount of short term external debt due from the private sector, which if not extended will create a large and unsustainable demand for dollars in the next three to six months. The amount of private sector debt as of March 1997 based on government estimates totals $56 billion, but this is an estimate and excludes commercial paper, medium term notes and other forms of short term obligations. The issue of presidential succession and choice of the cabinet also added to the increased political uncertainty. The level of uncertainty regarding political leadership is considered the highest for Indonesia compared with the other ASEAN countries.

Therefore, the perception that the government's efforts of reform were still not sufficient and the added uncertainties mentioned above were what led to the growing confidence crisis that contributed to the weakening of the rupiah beginning in mid September and lasted through the time the decision to go to the IMF on October 8. The rupiah weakened from around Rp. 3000 to around Rp. 3700 up to that time. The decision to ask for assistance from IMF was intended to offset the confidence crisis which had developed. As soon as the government announced that it would seek help from IMF on October 8, the market reacted with the rupiah strengthening and the stock market index. However when a few days later one of the Ministers made a statement that was interpreted, rightly or wrongly, as indicating that the government was having second thoughts about obtaining IMF help - the rupiah weakened and the stock market index dropped.

The rupiah and stock market index fluctuated quite widely after the announcement on October 8 until the time of the announcement of the IMF package at the end of October. The rupiah fluctuated between Rp. 3350 to Rp. 3600. The package was unique in terms of the amount and the related reforms announced. The total amount of the package amounted to $18 billion of multilateral commitments of $10 billion from the IMF, World Bank $4.5 billion (out of which $2 billion is quick disbursing), Asian Development Bank $3.5 billion (out of which $1.5 billion is quick disbursing). There is also a second tier standby credits in the event of adverse external circumstances offered by governments totaling $16.2 billion: Japan $5 billion, Singapore $5 billion, US $3 billion, Malaysia $1 billion, Brunei $1.2 billion and Australia $1 billion. The amount of assistance totaling $34.2 billion makes it is the second largest rescue since the bail out of Mexico of $50 billion, and double a similar IMF package to Thailand at $17 billion.

TThe reforms announced along with the package included the expected macro economic measures of fiscal and monetary policy. With respect to fiscal policy, steps aimed at increasing revenue (i.e. through strict discipline of non tax revenue), reducing expenditure and improving fiscal discipline will be undertaken to offset the short fall expected in the 1997/98 budget due to expenditure increases due to rupiah depreciation, and the lower income tax revenue receipts due to slower growth. Not only is the aim to avoid a budget deficit, but in fact to aim for a budget surplus amounting to 1 percent of GDP. Whereas monetary policy includes steps to release liquidity gradually, while at the same time still pursuing a single digit inflation target by controlling liquidity and interest rates.

Other than the macro economic measures, several reforms in the real sector were announced including the hoped for removal of the import monopoly on wheat, wheat flour, soybeans and garlic by the state logistics agency BULOG; further reduction of tariffs; removal of administrative retail price of cement in the near future; and removal of hindrances to exports including export taxes. In general steps in the right direction have been undertaken although the steps taken in BULOG were perceived to be half hearted since some of the liberalization are only effective in the next 3-5 years and although the import monopoly has been removed, the distribution of the commodities has not been deregulated. There was also less than hoped for in terms of restructuring or elimination of the national car program and strategic industries such as aircraft and ships, in general steps in the right direction were made.

On the national car it was stated that the government will be consistent with its commitments in the WTO, including implementing the decision of the WTO (i.e. in the case of the dispute panel currently undergoing in the WTO between Indonesia on the one hand and Japan, US and EU on the other) and that the local content program given to the national car will be eliminated by year 2000. The government also committed to improve efficiency of the State Budget by reviewing investment and expenditure by the public sector on strategic industries and state owned enterprises. Privatization will continue, including the merger of the State Owned Banks.

The government also moved boldly on liquidating 16 banks considered to be insolvent. The move was significant since the liquidation included banks owned by prominent figures including the son of the President and the brother of the President. Both parties have expressed strong public indignation at the move and the son has taken action to sue the Minister of Finance for wrongful revocation of the bank's license to operate. The case introduced a great element of uncertainty and some fears that if the decision would be reversed, market confidence would be greatly affected. Fortunately the case was withdrawn and the bank has sought a way out by being acquired by an existing bank. This was interpreted as evidence that the President was still exhibiting his pragmatism in the face of a crisis with the national interest in mind. Another liquidated bank in which the President's daughter has a small share, Bank Industri, also found a way out by merging itself with the three other related banks. It is possible that some of the other liquidated banks may find similar solutions thus avoiding a long drawn out liquidation process.

There was an initial panic from depositors at all private banks in the days after the liquidation move was announced as many rumors abounded regarding the possibility of a second round of liquidation. Almost all of the private banks, including the large ones, experienced a rush on their deposits on the first two working days after the announcement of the liquidation. The funds flowed partly to state and foreign banks, and some also stayed outside of the domestic banking system. The Central Bank, Bank Indonesia, has intervened by providing liquidity injections to the private banks and also intervening in the foreign exchange market to ensure that the rupiah is stabilizing.

The second largest private bank, Bank Danamon was affected by the rush compounding the effects of earlier bouts they experienced since July. This led them to divest 19 percent of their shares to the Salim group which also owns the largest private bank, Bank Central Asia. It is possible that Credit Suisse will come in with another 10 percent with the rest of the shares being held by the public. There is also news that the smaller banks have been warned by Bank Indonesia regarding their capital adequacy and encouraged to merge. In its reform package the government also hinted about the possibility of state banks being merged in the near future.

The announcement by the Central Bank governor that there would be no further liquidation, the withdrawal of the President's son court case against the Minister of Finance, and the initial smooth implementation of payment to small depositors, appear to have reduced the rush on private banks. Those with funds of up to Rp. 20 million have had their funds returned and it was announced that small depositors make up 93.7 percent of all depositors at the liquidated banks. Larger depositor will also receive up to Rp. 20 million of each deposit account. The central bank has prepared up to Rp. 2.3 trillion for this immediate need, and payment will be done through the various state banks. However there continues to be nervousness regarding the private banks which may take some time to dissipate and the private banks continue to have to offer high deposit rates.

The market reaction has been very positive towards the package with the rupiah soaring back up to Rp. 3250 on the following Monday and Tuesday after the announcement or an appreciation of 10 percent against the dollar (in rupiah terms). However, in the days following the announcement there continues to be weakening of the ruipah and the rupiah is likely to still fluctuate as the situation settles down, the possibility of further external contagion effects from Korea as well as possibly Thailand, and as the demand for the dollar will still be high due to repayment of debts in dollars. Furthermore, while market confidence may have been restored and investment climate improved, the reflow of capital will not occur immediately and thus growth recovery will take time to work its way into the system as discussed below.

Given the current currency crisis and drought situation, growth for 1997 and 1998 can be expected to slow down significantly. The government has stated that growth will decline in 1997 and 1998, but that it is predicted to go back up to an average of 7 percent by fiscal year 1999/2000 and in the years thereafter. It is estimated that growth for 1997 will fall to around 5.7 percent compared with 7.8 percent in 1996, with the slow down in growth mainly occurring in the second half. Drought and forest fires will impact on agriculture sector growth in the last five months of the year. Meanwhile all other sectors will experience a slow down in output growth in the second half of the year as the currency will lead to a reduction in output resulting from weaker consumer demand and the effects of the liquidity crunch on economic activity. The sectors most affected are expected to be the construction and trading sectors, and to a lesser extent manufacturing. Growth in manufacturing can still be expected from exports. Viewed from the expenditure side, domestic consumption and investment can be expected to slow down. Meanwhile the only source of growth will come from maintenance of export growth at a time when import growth has slowed down considerably.

Inflation up to October has reached 7.4 percent and in the remaining two months of the year, prices can be expected to go up due to the effects of the depreciation and a seasonal pick up of demand especially for food products towards the end of the year at a time when supply is affected by the drought. Inflation can be expected to reach 10 percent by year end 1997.

Non oil export growth up to July 1997 does not show signs of improving as yet at growth of close to 8 percent compared with 9 percent at the end of 1996. However some preliminary numbers would suggest that improvements in the third quarter coupled with depreciation should provide a boost to non oil exports in the second half of the year. Oil exports have also remained stable so that total export growth is expected to improve by year end. Meanwhile non oil import growth up to July 1997 had reached below one percent. Import growth can be expected to pick up slightly at the end of the year and beginning of next year due to the possible need to import food, given the drought and the peak in seasonal demand due to the fasting month and Idul Fitri holidays. The balance of trade has improved substantially, and in the January-July period had reached $5.2 billion or almost double the surplus reached in the same period last year of $2.7 billion. Thus, the trade surplus could be as high as $8-9 billion for 1997 and with a deficit in the services account estimated at around $15.5-16 billion, then the current account deficit will be an estimated $6.5-8 billion by the end of 1997/98 compared with $9 billion at the end of 1996/97. The decline in the deficit is a reflection of the slow down of the economy, and will be important also in view of expected lower capital inflows in the coming year.

The prospects for 1998 are more difficult to predict since the full implications of the IMF package and associated reforms are yet to still be fully worked out. The confidence crisis has been averted, but further external contagion effect may still impact on Indonesia and that there continues to be nervousness domestically as the implementation proceeds and its effects plays through. Under the best case scenario growth will still slow down to an expected 5 percent. The IMF is predicting only a 3 percent growth which is possible in a very slow investment recovery scenario.

The rupiah can be expected to fluctuate and even weaken slightly to accommodate the pent up demand for dollars, including legitimate demand to pay off dollar loans towards year end. In the best case scenario, the rupiah will strengthen again, as exporters are more confident about exchanging their dollars for rupiah, as export growth continues to pick up, and as investor confidence is restored so that there is a reflow of capital. However, the process of rupiah strengthening will only start being felt towards mid 1998 due to the continuation of a "wait and see attitude" by investors, domestic and foreign, of the presidential selection and make up of the new cabinet in March 1998. By year end 1998, the rupiah can be expected to strengthen to around Rp. 3,300 Rp. 3,500 per US dollar.

Interest rates can still be expected to be high by year end 1997 due to the continued nervousness about private banks. The central bank is slowly releasing liquidity back to the economy but at present there will still be a continued outflow for the reasons mentioned above. Deposit rates can be expected to still be around 25-30 percent and thus lending rates at 27-35 percent. Interest rates will only start coming down at the earliest after the first quarter of next year and if the best case scenario prevails then by year end the deposit rates will come down to 20-25 percent and lending rates to 22-27 percent.

Reflow of capital back to Indonesia and consideration of new investments are only expected at the earliest in mid 1998 under the best case scenario. Other than the successful negotiation and implementation thereof the IMF package, the best case scenario also means that the political leadership and cabinet selection in March 1998 is viewed positive in terms of the medium term policy outlook. At the same time consumer demand is likely to remain sluggish in the wake of the wealth effect that consumers are facing due to the currency crisis and the specter of unemployment that will affect many people. The only source of growth will be exports and continued sluggishness of imports. Assuming the process of transition progresses smoothly and that the world economic outlook remains bright then, recovery can only start being felt at the earliest at the end of 1998 or beginning of 1999. Thus, we are looking a period of slowdown for the next 12 to 24 months.

The good news is that improvement in the trade surplus could still be experienced in 1998 as growth in exports is expected to be maintained due to the boost in competitiveness achieved due to the depreciation of the rupiah. Meanwhile import growth will remain low as investment growth will not begin to pick up until towards the end of the year. The services account will remain high and thus the current account deficit can be expected to improve slightly but still be high. The government is targeting that the current account deficit in the balance of payments will come down to 3 percent of GDP within the next two years.

Inflation will be higher in 1998 than in 1997 due to the effects of drought, fasting month and Idul Fitri expected to have a substantial impact on food prices in the first quarter of 1998. In the 1994 drought episode, inflation in the first quarter of 1995 reached above 3 percent. There will then be price increases in the second quarter due to the expected increase in the price of fuel and electricity rates. Thus, the inflation outlook for 1998 will be around 10-11 percent.

What about policy direction? The policy reforms in the IMF package include fiscal, financial and real sector reforms. In the fiscal policy area, the rationalization of the budget and efforts to increase revenues for the government is expected to continue. Difficulties are envisaged in terms of budgetary discipline as it will require greater transparency and institutional capacity building which will take time. Further financial sector reforms will include a continued tougher stance on banks and financial institutions, and anticipated further rationalization through mergers occurring, including for state banks.

While continued deregulation may be expected in the real sector, there continues to be distortions and high cost economy factors remaining which can only be addressed through strong political will, institutional capacity building, improving effectiveness of policy implementation and legal certainty as well as protection, and greater transparency and accountability by the government and the private sector. Since the crisis and its aftermath are not likely to be over by March 1998, that the make up of the 1998 cabinet will be strongly in favor of the technocrats.

The currency crisis, drought and forest fires, are expected to lead to increased unemployment and increased tension especially in the outer regions most affected. Drought will mean that workers usually employed as harvest labor will be unemployed and they will not be absorbed as construction workers either due to the slowdown in the property sector. In fact the Association of Real Estate Indonesia has already announced that their industry had already retrenched some 40,000 workers and will have to lay off around 90,000 more if the tight liquidity situation is not alleviated soon.