The Chastening

by Paul Blustein

  The spats were, in a sense, bureaucratic tempests, typifying the differences among these organizations—one hierarchical and built for speed, the other two diffusely managed and accustomed to long deliberations. But the feuding had a cost. An Indonesian official chided one World Bank staffer: “The patient is dying, and the three doctors are fighting.”

  For cynics accustomed to seeing well-connected Indonesians receive sacred-cow treatment, the announcement on November 1 of the Just-finalized IMF program contained some remarkable news. Sixteen private Indonesian banks were to be closed for lack of solvency, and the list included several whose major shareholders were linked to the Suharto clan. Among them were Bank Andromeda, of which 25 percent was owned by the president’s son Bambang; Bank Jakarta, which was owned by Suharto’s half-brother Probosutedjo; and Bank Industri, part-owned by Suharto’s daughter, Siti Hedijanti Herijadi, and Hashim Djojohadikusumo, her brother-in-law.

  The bank closures were the central element in the IMF program, which provided Indonesia with a $33 billion package of loans, including pledges of $10 billion from the Fund, $8 billion from the World Bank and ADB, and $15 billion in backup credit lines from Japan, Singapore, the United States, Australia, and Malaysia, to be made available if needed. Besides shutting the troubled banks, the Indonesian government agreed to a number of structural reforms aimed at curbing the privileges enjoyed by Suharto Inc., including a phaseout of several BULOG import and marketing monopolies, with wheat, soybeans, and garlic becoming immediately open to imports. The cement cartel would be opened to competition by giving up its right to control retail prices, and the chemical industry would lose some of its tariff protection.

  Many foreign analysts praised the bank closures in particular as a sign that Indonesia was being forced to change its ways, and in the first few days following the program’s announcement, the rupiah rose by about 10 percent, to the 3,200-per-dollar range, though that was thanks largely to a surprise series of interventions to buy up quantities of the Indonesian currency by the Singaporean central bank as well as Bank Indonesia and other Asian central banks.

  But toward the end of the first week of November, the reaction to the bank closures took an ominous turn. Anonymous lists of “good banks” and “bad banks” began circulating around Jakarta, often arriving by fax in bank and brokerage firms’ offices, purporting to tell which banks were safe from closure in the future and which ones were likely to Join the sixteen already shuttered. Before long, a full-fledged run on privately owned banks was under way. Bearing bags and boxes to hold cash, crowds thronged to withdraw their deposits from branches of the giant Bank Central Asia, owned by Suharto’s pal Liem Sioe Liong, in the second week of November. Many depositors rushed their money from private banks to state-owned banks, figuring the state-owned ones, whatever their problems, were at least backed by the government; others showed up with bags of rupiah to deposit at the Jakarta branches of Citibank and other foreign institutions. By the end of November, privately owned Indonesian banks had lost 12 percent of their rupiah deposits and 20 percent of their foreign currency deposits, raising the alarming scenario of a series of cascading failures in which the inability of one or two banks to pay their obligations would cause the others to default, eventually leading to a systemwide collapse that would paralyze the nation’s economy.

  Sudradjad, who as central bank governor had resisted many of the bank closures, watched with a mixture of agony and frustration as the bank runs accelerated. “From the foreign market’s point of view, the policy [of closing the sixteen banks] was credible because even banks owned by people close to the Suharto family were being closed,” he said. “But domestically, people said, ‘Wow, if more banks are weak, and even banks belonging to people in the president’s family are being closed, then there must be others next.’ It may sound crazy, but that’s what I encountered. You’re damned if you do, and damned if you don’t.”

  The problem was not Just that banks had been closed; it was the way they were closed. The IMF believed, understandably, that it had to close at least some banks, since the markets knew the banking system was riddled with bad loans, and permitting the sickest ones to continue to operate would have sent a terrible message. But shuttering banks can be done artfully, or it can be done ham-handedly.

  When done artfully, bank closures work like successful cancer surgery, in which the surgeon removes all the malignancy from the patient’s body at once and leaves nothing but healthy tissue. The key, though, is to be convincing about how healthy the remaining tissue is. If the public suspects that some malignancy remains—in other words, that some rotten banks have survived—closures may lead to bank runs because depositors fear more closures are on the way.

  Franklin Delano Roosevelt pulled it off in his first fireside chat on March 12, 1933, after widespread bank runs had led him to order all U.S. banks shut for ten days while auditors went in to inspect the books. Although 7,000 banks were shut permanently, Roosevelt persuaded the public through the sheer power of his rhetoric that the surviving banks were sound. “I can assure you that it is safer to keep your money in a reopened bank than under the mattress,” he declared. “Let us unite in banishing fear.... It is your problem no less than mine. Together we cannot fail.”

  Of course, this kind of trick is much easier in an advanced country like the United States than in a developing country like Indonesia, because in Indonesia the bank regulators’ reputations for competence and honesty are open to serious question. Closing banks in such a country—especially one with a history of few closures, and especially one where more closures appear likely—requires strong measures to maintain public faith in the banking system. That may mean providing a government guarantee on all deposits, at least temporarily. Indeed, the Fund had endorsed Just such a policy in Thailand, but many on the Fund staff and on the IMF board felt uncomfortable about supporting expensive taxpayer-backed guarantees on bank deposits, and they wanted to draw the line against them in Indonesia. On this score, the IMF’s policy in Indonesia “now appears to have been ill-advised,” as the Fund’s 1999 staff report evaluating the Asian programs later acknowledged. This is about as close as the Fund gets to saying, “We blew it.”

  When the sixteen banks were closed, the Indonesian government—with IMF advice and support—announced that it would guarantee all deposits up to 20 million rupiah (about $5,000), the idea being to protect small depositors, who were far more numerous than rich ones (though they held a minority of the deposit base). That guarantee proved woefully inadequate to induce confidence in the system.

  A major part of the problem was the widespread impression that the Fund hadn’t persuaded the Indonesians to close all the banks that would need to be closed eventually. After all, the sixteen shuttered banks accounted for less than 3 percent of all deposits in the system, and they had been selected in a hectic process involving untidy compromises with the Indonesians, recalled Jack Boorman, director of the IMF’s Policy Development and Review Department. “We were getting faxes on a minute-by-minute basis, with people poring over information from the banks,” he said. “And one of the elements that drove that final decision was that we were looking at the owners of the banks. How far could we go? How many toes could we step on? How many could the governor of the central bank afford to step on? We needed to be as sure of our facts in the case of each bank as we could be under the rather chaotic circumstances. That’s why it stopped at sixteen.”

  A related problem was Suharto’s fault, not the Fund’s. The President’s son Bambang, aggrieved over the closing of his Bank Andromeda, was allowed to take over a smaller bank, Bank Alfa, in late November. He brazenly announced that he was transferring the original bank’s assets there so that, “in short, Andromeda is only changing its name.” He admitted that his bank had violated regulatory guidelines by lending $75 million to its owners and their affiliated businesses, including a petrochemical venture he was involved in, but he offered the excuse that 90 percent of Indonesian banks
had done the same sort of thing.

  Plainly, much malignant tissue remained in the banking system. Because the IMF was thwarted from excising all of it, the Fund should have anticipated runs by depositors fearful that their banks would be closed. But when the runs started, “there was not a clear and decisive strategy to deal with that problem,” as Mussa delicately put it, because “it was not well thought out in advance of the program, by us or by them.” At this point, blunders began to compound themselves.

  One fairly obvious solution might have been adopted by the IMF and the Indonesians to restore confidence in the banking system; in fact, Mussa and some others at the IMF were hoping to see it happen at the time. A full government guarantee could have been announced on all bank deposits, and simultaneously, another batch of sick banks could have been closed, eliminating as much of the malignancy as possible.

  But the opportunity for such a deal slipped away as Indonesia’s crisis deepened in the second half of November and December 1997. First, Suharto became quite ill in early December after returning from an arduous overseas trip. The precise nature of his ailment was never disclosed, but his cancellation of public appearances for ten days terrified the markets, which drove the rupiah below 4,000 per dollar on December 5 and 5,000 per dollar on December 12. Under his iron-fisted rule, Suharto had arrogated so many of the levers of power to himself that investors became worried his death or incapacity would leave the country rudderless and exposed to clashes among feuding groups.

  Another factor preventing a deal on the banking problem was that relations between the Fund and the Indonesian government were strained thanks in part to the shenanigans involving Bambang and the reopening of his bank. Sudradjad and his reformist colleagues had fallen into Suharto’s disfavor; they were in no position to push for more bank closures or a 100 percent deposit guarantee, an idea Sudradjad strongly disliked anyway.

  Just as important, the IMF itself was badly split. The Monetary and Exchange Affairs Department was vehemently opposed to a comprehensive deposit guarantee. After all, recklessly run Indonesian banks had been offering astronomical interest rates to lure deposits from rich Indonesians; using taxpayer money to guarantee such deposits would be validating—and encouraging—the most irresponsible sort of financial behavior. Moreover, in some cases, bank owners had been paying themselves and their cronies high interest rates on their own deposits—hardly the sort of people who seemed deserving of being protected against loss.

  Here again was the problem of moral hazard, a classic trade-off that often confronts financial-crisis fighters—restoring stability now versus punishing the guilty and discouraging imprudence later. Gross injustices would be committed, and lousy precedents would be set, by guaranteeing deposits and letting some slimy bankers and depositors off the hook for their misdeeds. But as Mussa put it, “If the alternative is what we’ve seen happen to the Indonesian economy, that’s real hazard.”

  That argument was advanced by others in the Fund, including Joshua Felman, a senior member of the mission to Jakarta, who became emotional over the issue, accusing the moral-hazard zealots of “using 200 million people as guinea pigs for your theories.” Felman, colleagues recalled, got into pitched battles with Vaez-Zadeh and others in MAE. He conceded their point that a blanket guarantee of deposits would have costly long-run consequences. But he didn’t accept their analysis of the Indonesian banking system as being essentially healthy and having only a few “bad apples” that needed to be removed from the barrel and tossed out. Indonesia’s banks faced a “systemic” crisis, he argued, because the decay in the system was much deeper than the official central bank figures indicated—deep enough, anyway, that the richest and best-connected Indonesians knew better than to trust the banks with their money in the absence of full government backing.

  Felman couldn’t prove his point. He was not a banking expert, and he lacked the data to support his case. The World Bank’s financial experts, who had good insight into the parlous state of the banking system, were attached to Vaez-Zadeh’s team and not interacting with Felman, who belonged to the Asia and Pacific Department.

  With the Fund divided, the issue was left to fester in December, when the crisis in Korea diverted much of the time and energy of the IMF and the rest of the High Command. Meanwhile, Indonesia’s banking crisis was morphing into yet another problem.

  In his office at Bank Indonesia, Sudradjad was sprawled in his chair, his arms outflung like Christ on the cross, when he was visited by an IMF mission member in late autumn of 1997. “There is this Catholic maniac on one side, and a Muslim maniac on the other side, and I am coming apart!” the central banker complained. The Catholic maniac to whom he referred was Camdessus, who represented the demands of the IMF hierarchy for high interest rates; the Muslim maniac was Suharto, who was ordering the central bank to keep cheap credit flowing to Indonesia’s cash-starved banks and companies.

  The dilemma was indeed acute. The bank runs, sufficiently serious by themselves for the state of confidence in the economy, were contributing to a mess in the money supply. Because so many depositors were withdrawing their money, Sudradjad was facing demands from commercial banks for emergency loans of rupiah. Making such emergency loans, as noted previously, is part of a central bank’s function as lender of last resort in a crisis. But with so much rupiah being pumped into the banks, the money supply began to rise explosively—so much so that by the end of 1997, Bank Indonesia’s currency department, which was having trouble increasing production of rupiah banknotes, resorted to releasing some plastic 50,000 rupiah notes manufactured a couple of years before as souvenirs for the country’s celebration of its fiftieth anniversary of independence. (The notes failed to sell well as souvenirs but then served a function as legal tender.)

  The money supply might seem an odd issue to focus on in a history of the Indonesian crisis, which in the popular mind was all about Suharto and his cronies. But monetary policy proved an important factor in Indonesia’s downfall, for much of the ballooning quantity of rupiah wound up being sold for dollars on the open market and shipped to Singapore, Hong Kong, and other offshore locations by Indonesians desperate to get their money out of the country.

  Who was engaging in this capital flight? That is impossible to answer precisely. But again, some of it can surely be ascribed to members of the ethnic Chinese minority, whose worries were understandably growing as Suharto’s grip on power began to look ever more tenuous. Loose money wasn’t what scared them, but it helped accelerate their exodus from the rupiah.

  Within the IMF, arguments flared over the monetary issue in late 1997. Alarms were sounded by the “hawks,” who favored using tight credit and high interest rates to combat currency crises; they included the Policy Development and Review Department and executive directors from the United States and some European countries. The rapidly growing supply of rupiah, the hawks feared, would surely lead to a further erosion in the value of the Indonesian currency against the dollar. Moreover, they asserted, Indonesian interest rates had to be kept high to maintain incentives for people to keep money invested in the country. Yes, Bank Indonesia had to supply cash to banks suffering runs, but the only way it could save the rupiah, in the hawks’ view, was to drastically tighten the overall supply of credit, even if that meant interest rates would rise to stratospheric levels—100 percent or more—at least temporarily, until the situation settled down. “Don’t give me this crap that [with interest rates so high] no Indonesian company can afford to buy a machine,” one hawk recalled arguing. “You’re in the middle of a currency crisis. What’s important is, do you as an investor want to hold the rupiah until next Monday morning?”

  Aghevli, Felman, and others in the Asia and Pacific Department disagreed. Interest rates were already punishingly high, they contended, pointing to the fact that some Indonesian banks, in their desperation for funds, were offering 75 percent annual rates. In response to the counterargument that they were looking at the wrong interest rates—state and
foreign banks, which were flush with deposits, were offering between 15 percent and 30 percent—they retorted that pushing rates a lot higher wouldn’t be credible to the markets, because with the banking system on the verge of collapse, everyone knew that the banks couldn’t afford to pay such a high cost for their funds for more than a few days. “They would say, ‘Monetary policy is fine,’” Karin Lissakers recalled, referring to Aghevli and his allies. “We would say, ‘No, it’s not.’ We would sometimes have three or four meetings a week. It was never a question of dogma. It was a genuine intellectual debate.”

  Who won? The “Muslim maniac” did, in the sense that Sudradjad continued injecting more cash into the banks as the runs continued and the crisis atmosphere intensified. Figures would later show that the rupiah streaming from the central bank into the banking system in December and January was equal to almost 10 percent of Indonesia’s GDP, and the amount of currency circulating in the economy rose by one-third. (Subsequent investigations would show further that large central bank loans were improperly extended to banks and companies with political clout.) Aghevli, bowing to the wishes of his superiors, pressed for a tighter credit policy—to little effect.

  The massive emission of money fanned the flames of the crisis and increased downward pressure on the rupiah throughout December. But the underlying problem was the bank runs, which were still unaddressed. Since confidence in the banking system had all but vanished, no good monetary policy choice existed—as even some among the Fund’s interest-rate hawks would later acknowledge. “Bank Indonesia was caught in a virtually impossible situation,” Mussa said, because as bad as it was to let the money supply explode, “if it had allowed the banking system to fail, that would have been an economic calamity.”