The year 1998 was, for Indonesia, one of prolonged financial instability and crisis which negatively affected the performance of the Indonesian economy. Production declined significantly as a result of accelerated inflation and high interest rates. The inflation was provoked by imported inflation stemming from accentuated rupiah depreciation and domestic supply shortages.

In response to this aggravated condition, a broad-based policy package was implemented, with the financial support of the IMF. The policy package included: (i) a tightening of monetary policy, with sharply higher interest rates and strict control over central bank net domestic assets; (ii) an adjusted fiscal framework that took into account the less favorable outlook for growth and allowed for the cost of bank restructuring, as well as expenditures to cushion the impact of the crisis on the poor; (iii) an action program for the restructuring of the banking system; and (iv) a number of additional measures constituting a far-reaching structural reform and adjustment program to improve efficiency.

With consistent implementation of the policy package, signs of early recovery started to emerge in the first quarter of 1999. The economy has bottomed out, the rupiah strengthened, inflation pressures subsided, the interest rate continued to decline and the stock market rebounded.

The financial turbulence had a negative impact on economic activities, resulting in a deep contraction of GDP by 13.7% in 1998, as compared with 4.9% growth in 1997. The contraction was primarily seen in a sharp decline in private investment and lower household consumption. The weakened household consumption was brought about by a loss of purchasing power stemming from accelerated inflation and sharp rupiah depreciation. Private investment contracted due to a deterioration in cash flows as the external debt burden increased substantially, notwithstanding higher interest rates and limited access to bank credit from both domestic, as well as overseas banks.

However, the most recent evidence shows that the recovery process is underway. On the annualized quarterly basis, the economy grew by 5.4% in the first quarter, followed by 1.8% growth in the second quarter. On the annual basis, the real GDP grew by 1.8% in the second quarter as compared with previous year, confirming the first year to year pick up in growth since the fourth quarter of 1997.

In 1998 the annual inflation rate reached 77.6% as compared with 10.3% in 1997. The accelerated inflation was mainly reflected in higher prices of food and other essential items. These conditions were aggravated by disturbances in the distribution system and supply shortages due to adverse weather, which had led to a poor harvest.

After recording a skyrocketing inflation rate in 1998, inflationary pressure subsided in the first half of 1999. In January 1999, monthly inflation reached 2.97% and fell to 1.2% in February, and even turned into deflation in the four subsequent months, that is, -0.18% in March, -0.68% in April, -0.28% in May, and -0.34% in June 1999.

With deepening contractions in the economy during 1998, the unemployment rate in Indonesia increased substantially as a direct result of an unstoppable wave of layoffs in a number of sectors. The immense pressure originating from rising production costs on the one hand, and shrinking domestic market absorption on the other, had caused a large number of entities to downscale their operations. In the meantime, minimum real wages dropped as a result of the rising inflation. The open unemployment figure, which reached 4.3 million in 1997, climbed to 5.1 million in 1998, equal to 5.5% of the total labor force. If estimated underemployment, of as many as 8.6 million people, were counted as unemployment, unemployment would have totaled 13.7 million.

In 1998, the deficit in Indonesia’s overall balance of payments (BOP) position narrowed to around US$612 million as compared to a deficit of US$2.5 billion in 1997. The deficit stemmed from a deficit in the capital account of around US$4.6 billion (4.4% of GDP) while the current account recorded a surplus of around US$3.9 billion (3.8% of GDP). This capital account deficit was due to huge private capital outflows, which offset official capital inflows (around US$9.9 billion) originating from foreign assistance. The net private capital outflows (including FDI) recorded a deficit of US$14.5 billion. In the first quarter of 1999, the capital account recorded a surplus of US$762 million. The surplus was attributed to the increase in official capital (net) by $3.5 billion, while the private capital (net) still posted an outflow of US$2.7 billion.

However, the overall external payments position in the first quarter of 1999 is expected to record a surplus of US$2.2 billion. The balance of payments surplus is driven by surpluses in the current account (around US$1.4 billion) and the capital account (around US$762 million) as net official inflows surpassed net private outflows.

During the first quarter of 1998, the exchange rate was subjected to speculative attacks. It plummeted from Rp 4,650 per US dollar in December 1997 to around Rp 16,000 per US dollar on January 22, 1998. However, at the end of April 1998, it strengthened to Rp 8,325 as the market positively responded to the central bank’s policy to raise the Bank Indonesia Certificate (SBI) rate and the government’ attempts to settle private sector debt. The social unrest occurring in May 1998 undermined confidence in the economy and led to renewed pressure on the rupiah which fell to its lowest level of around Rp 16,800 per US dollar in mid-June.

Entering the second quarter of 1998, the rupiah rate strengthened from an average of Rp 14,300 per US dollar in July to averages of Rp 12,000 and Rp 10,900 in August and September, respectively. The authorities’ strict adherence to strong monetary discipline, the renewed financial support from the international financial institutions, and the successful national debt restructuring brought a positive impact in the exchange market.

The rupiah exchange rate continued to strengthen significantly in the subsequent months, from a level of Rp 10,700 per US dollar at end-September to a range of Rp 7,500 to Rp 8,000 at the end of 1998, despite increased social and political tensions.

Entering 1999, the rupiah faced additional pressures stemming from various internal and external factors. After some rebound to around Rp 8,500, in early March the rupiah declined to about Rp 9,000 per US dollar. Upon the announcement of the bank restructuring on March 13, 1999 the rupiah strengthened and reached the range of Rp 8500 to Rp 8,800.

Currently, the rupiah is strengthening in the range Rp 6,700 to Rp 7,000, as there is growing optimism about the prospect of the economy and the peaceful completion of the June Parliamentary elections.

For fiscal year (FY) 1998/99, the overall balance recorded a deficit of 2.2% of GDP, an increase from the deficit of 0.8% in FY1997/98. Total central government expenditures witnessed a small (approximately 1.2% of GDP) increase between FY1997/98 and FY1998/99. This net increase is more than accounted for by two crisis-related factors. First, with the currency depreciation, government interest payments on the external debt increased by about 0.7% of GDP. Second, as explained below, spending on social safety net measures was increased. The net expenditure effects of these two developments outweighed the crisis-prompted cuts elsewhere in government spending (for example in development expenditures), which were cut by more than 0.3% of GDP.

Looking at the 1999/2000 budget, there are four main budgetary objectives. First, the budget incorporates a high-quality targeted fiscal stimulus to support demand, especially through higher development spending. Second, steps are being initiated to rebuild the revenue base over the medium term. Third, gross interest costs of bank restructuring approximately 3% of GDP have been incorporated in the budget. Fourth, the traditional principle of avoiding domestic bank financing for regular budgetary operations will remain, if necessary, by invoking contingency measures. Government bonds are to be issued only for bank recapitalization. The overall budget deficit is projected at nearly -4.4% of GDP in 1999/2000.

To stabilize the exchange rate and to reduce the inflation rate, a tight monetary stance was adopted to compensate for the excess supply of money stemming from the large scale liquidity support to commercial banks. As the tight money policy stance was adopted, interest rates on one-month SBIs rose sharply from 22% in January to 58% on May 7, 1998. Subsequently, deposit rates rose substantially, to roughly 60%. To enhance the effectiveness of open market operations (OMO) and to activate the secondary market, Bank Indonesia initiated a new SBI auction system by announcing on July 29, 1998, the target quantity of SBI (central bank certificates) intended to be sold. In addition, Bank Indonesia also directly intervened in the rupiah money market in order to achieve its base money target.

As inflationary pressures subsided and the rupiah strengthened, some pressures have been taken off the monetary policy, permitting a gradual reduction of interest rates within the context of the overall monetary policy program. The benchmark SBI auction rates declined subsequently to around 37% at the end of December. Entering 1999, interest rates have showed a continued declining trend. In the 30 June 1999 auction, SBIs reached 18.84%, bringing about a decline in deposit rates (one month) to around 20%.

Over the past six months, the key macroeconomic indicators of the Indonesian economy have shown that the worst of the crisis is over and the road to economic recovery has picked up. These positive achievements were further supported by the peaceful parliamentary elections in June, which in turn prompted the run-up in the stock market as confidence in Indonesia’s economic prospects started to recover. Against these recent developments, the Indonesian economy in 1999 is projected to experience a much lower contraction rate as compared with the unprecedented negative growth of 13.7% last year.

The inflation rate by the end of 1999 is projected to be lower than 10%. The projected single digit inflation rate is likely since during the first six months the cumulative inflation rate has only reached 2.73%. Assuming the monthly inflation rate for the next seven months will be below 1%, the end year inflation rate is therefore estimated to reach around 8% or 9%.

In step with decelerated inflation, it is estimated that the rupiah exchange rate will stabilize with a range of Rp 6,000 to Rp 6,500 by the end of 1999. Meanwhile, domestic interest rates are expected to reach around 10% to 15% .

Against this background, two short-term scenarios are presented to project the growth of the Indonesian economy. The optimistic scenario is based on the assumption that progress in the bank and corporate restructuring program will proceed smoothly, that capital will begin to flow in at the third quarter of 1999, and a peaceful coalition government can be formed to ensure political stability. Under this optimistic scenario, real GDP growth is projected to be close to 0%.

In contrast, the downside scenario is based upon the assumption of a slower bank recapitalization and corporate restructuring process; difficulties in reaching consensus to form a strong coalition government; and a possible delay of disbursement of foreign borrowings. Under this scenario, the growth rate is projected to be around -2%.

Bank Indonesia, with support from the IMF, set quantitative targets for base money and its components, namely net international reserves (NIR) and net domestic assets (NDA), which have served as operational guidelines. With a view to strengthening the credibility of the policy among market players, the targets and performance have been made transparent through periodic announcements.

To achieve the quantitative target, on 29 July 1998, Bank Indonesia changed the auction system of Bank Indonesia Certificates (SBIs) whereby the emphasis was shifted from an interest rate target to a quantitative target.

The banking restructuring program was one of the priorities of the government’s economic agenda. To restore confidence, the government continued its guarantee program for the safety of deposits up to the year 2000 and broadened the scope of the guarantee to include rural development banks.

In rehabilitating the soundness of the banking system and enhancing its resilience, as well as precluding a recurrence of bank runs in the future, the government continued the banking restructuring program that it had begun in the early 1999. The program rests on four pillars of policy, namely: (i) measures to restructure banks, primarily through a recapitalization program, (ii) measures to fix internal conditions, (iii) measures to improve bank regulations and law enforcement, and (iv) measures to strengthen supervision functions.

In line with the bank restructuring agenda, amendments of the banking law were approved by the parliament on 16 October 1998. These new amendments strengthened the legal power of IBRA (Indonesia Banking Restructuring Agency) and the AMU (Asset Management Unit). In addition, a new central bank law, which provides for greater independence for the central bank (Bank Indonesia), was enacted by the parliament on 16 April 1999. Furthermore, a law covering foreign exchange movements and the exchange rate system was passed. This bill allows Bank Indonesia to monitor capital flows and to implement the exchange rate system adopted by the government.

One of the important steps in solving the corporate debt overhang, besides recovering access to international sources of fund, was the Frankfurt Agreement which was reached on 4 June 1998. The Frankfurt Agreement covers interbank debt settlement, trade financing, and private corporate debt.

To resolve the corporate debt overhang, the government has set up the Indonesian Debt Restructuring Agency (INDRA). The government has also provided INDRA with facilities to speed up the negotiation process between debtors and creditors through the Jakarta Initiative.

To upgrade the institutional and the legal framework of Indonesia’s economy, the government issued a number of new laws. The new laws included legislation dealing with bankruptcy, anti-monopoly, banking, and the establishment of a commercial court.

The government initiated a number of measures to alleviate the adverse effects of the crisis, particularly on the poor and low-income families. On the fiscal front, the government raised expenditures that were associated with the social safety net and the subsidies on oil-based fuel, electricity, medicine, and foodstuffs.

Indonesia: Overall Economic Performance

Source: Data are as submitted by member economies, unless otherwise specified.

Table 2. Forecasting Summary (% change from previous year)

Note: The IMF forecast is from the World Economic Outlook (IMF, April 1999). The ADB forecast is from the Asian Development Outlook (1999). The OECD forecast is from the OECD Economic Outlook (OECD, June 1999).