The Chastening

by Paul Blustein

  The package read like the World Bank’s wish list for reforming every rotten, wasteful distortion in the Indonesian economy, and for Dennis de Tray and his Jakarta-based team, who played a central role in drafting the structural conditions, it was a triumph. “Tommy” Suharto’s National Car project would lose all of its subsidies, and his control over the clove trade would be abolished. B. J. Habibie, the nationalistic technology minister, would lose government funding for his cherished project to build commercial aircraft. The president’s daughters would suffer the cancellation of power-plant projects they had invested in. Tycoons close to Suharto who controlled cartels or monopolies over the trade in palm oil, plywood, paper, and a host of other products would be forced to face the chill winds of competition. Such measures might not be crucial to the performance of the Indonesian economy, de Tray and his colleagues knew, but they were of immense symbolic significance to average Indonesians, who were becoming fed up with the excesses of the elite. Instead of grudgingly allowing piecemeal reforms as in the past few months, Suharto now had a chance to get ahead of the curve and show his country—and the world—that he truly “got it.”

  One huge, unanswerable question looming over the negotiations was whether Suharto really intended to deliver on the program, with all the financial pain it would entail for his loved ones and lifelong allies. Fischer believed that the IMF had sound reasons for assuming that the presidential pledges were genuine, because Suharto intended to sign the Letter of Intent personally, instead of leaving it to the finance minister and central bank governor as is the usual custom. “We were told by a senior politician in the region that we must have Suharto sign—it won’t mean anything if the finance minister signs,” Fischer said. “But if Suharto signs, that’s it.” Camdessus, for his part, went to Suharto’s house for several hours on the evening of January 14, going over the accord line by line, making sure the president understood exactly what he was signing. Suharto assured Camdessus that he had already summoned his six children to explain what he was being asked to do, and they had urged him to take whatever steps were necessary for the country’s good.

  But another question was whether putting all these reforms in an IMF program made sense. Paul Volcker, the former Fed chairman, didn’t think so. At the time the negotiations for the January 15 program started, the Indonesian government had asked Volcker, whose height of six feet, seven inches reinforces his giant stature in policymaking circles, to fly to Jakarta and offer some advice. Leafing through a confidential draft of the IMF’s conditions, Volcker was surprised to see items such as the termination of the clove monopoly. “I’d never read an entire Fund program before,” Volcker recalled in his gruff baritone, “but it was a long plane trip. And I’m half asleep, and I get to page forty-six or something, and there I see [the provision dismantling the monopoly on cloves].”

  What did spice monopolies have to do with restoring financial stability? Volcker demanded of IMF officials when he arrived in Jakarta. “They said, ‘You don’t understand. It’s run by Suharto’s son, and if we don’t do anything about it, nobody will say we’re serious,’” recalled Volcker, who was still not entirely convinced of the merits of the Fund’s approach. “People have different philosophies,” he said. “The Fund’s business is macro policy, and that’s the stuff you can change. How programmatic you can be, in things that go into basic cultures and economic structure—whether that’s productive or counterproductive, well, it’s a continuing issue, that’s all I’ll say.”

  But no amount of skepticism could halt the momentum in favor of a full-bore attack on KKN. Reformers in the Indonesian government were generally pleased with what was happening. Some worried that by targeting the businesses of the people close to Suharto, the program risked backfiring, because even if Jakarta delivered on most of the measures, the president’s failure to deliver on a few politically sensitive ones would become the focus of attention. But most were glad for the opportunity to achieve measures they had long favored, and within the IMF, there were few doubts that the package was going to take the world—and the markets—by storm. A thrilled Camdessus met with the Joint IMF-World Bank mission, thanked members for their hard work, and told them Suharto’s concessions had far surpassed what he was expecting. “I am confident that in a few days, this will be over and you will be home with your families,” he said.

  One of the Washington-based World Bankers, Florence Cazenave, demurred. In meetings over the previous few days, colleagues recalled, she had expressed worries that the anti-KKN and structural reform measures in the package did not deal with the issues most worrisome to the markets. The program, she argued, should focus on addressing the problems of the banking system and the foreign debt burden of Indonesian corporations. “I would love to go home,” she said at the meeting with Camdessus, “but we have still not started on the problems of the financial sector.”

  For most of the others, though, it was unimaginable that the reform plan’s announcement would be followed by anything other than a rise in the rupiah. “We had produced one of the most comprehensive reform packages in history,” said de Tray. “There was a real sense of euphoria. We thought, ‘If this doesn’t surprise the market, nothing will.’

  “And by God, nothing did.”

  The room was packed, and the excitement level high, as Camdessus stepped before the TV cameras and microphones at mid-morning on January 15, 1998, to unveil the “much strengthened and reinforced” program that Suharto had Just signed. Speaking in almost rhythmic cadence, with pauses for emphasis before the crucial verbs and adverbs, the IMF managing director announced the highlights: Budgetary and extrabudgetary support and credit privileges granted to IPTN’s airplane projects [run by Habibie] will be discontinued.

  ... all special tax, customs, and credit privileges for the National Car project will be revoked, effective immediately.

  ... BULOG’s ... monopoly over the import and distribution of sugar as well as its monopoly over the distribution of wheat flour will be eliminated.

  ... The Clove Marketing Board will be eliminated, by June 1998.

  ... the cement, paper, and plywood cartels will be dissolved.

  ... by February 1, all formal and informal barriers to investment in palm oil plantation will be removed.

  Roberto Brauning, an IMF external relations officer, watched an Indonesian reporter whose eyes, Brauning recalled, “kept getting wider and wider” with the enumeration of each reform that Suharto had accepted. The reporter, and many of his Indonesian colleagues, burst into applause at the end of the managing director’s statement.

  After the press conference, Aghevli and three other IMF staffers went to lunch in a hotel restaurant and, in a celebratory mood, ordered a bottle of wine. “We were all very pleased,” Aghevli recalled. But the team’s sense of exhilaration abruptly vanished when Aghevli called on his mobile phone to find out how the rupiah was faring in the currency markets and learned that it was dropping sharply. “I couldn’t believe it,” Aghevli said.

  The rupiah fell 6.5 percent against the dollar that day, another 5.4 percent the next day, and plummeted to 15,450 rupiah per dollar on January 23. For anyone who has wondered what it means for an economy to “melt down,” this period of Indonesia’s crisis offered some phantasmagoric illustrations.

  Prices fell completely out of whack amid the precipitous cheapening of the currency. An obvious example was taxi rides; you could flag down one of the luxurious, air-conditioned cabs that service the tourist trade, let the meter run as you spent four hours shopping or zipping to meetings, and with the rupiah-dollar exchange rate in five digits, the cost would be the equivalent of $3 to $4. You could order a double cheese, medium pizza with pepperoni from Domino’s (yes, there are Domino’s outlets in Jakarta), and the cost in rupiah would be less than $1.

  Enterprising traders were buying up caseloads of internationally branded goods like Camay soap and Marlboro cigarettes—a pack of Marlboros went for the equivalent of about 20 cents—an
d shipping them for resale to neighboring countries, where they could fetch three times the price. But that was for goods previously imported; prices of newly imported goods were soaring beyond the reach of ordinary Indonesians. Auto dealers were raising the prices of cars two or three times a week, and some were insisting on waiting until delivery to finalize prices.

  And life was getting harder for the newly unemployed, whose numbers were reported to be approaching 1 million and rising fast. Riots were erupting in several East Java towns because of anger over the rising price of rice, cooking oil, and other staples. Runs on banks were intensifying, and foreign companies were quietly preparing their employees for a possible reprise of The Year of Living Dangerously . “You keep $1,000 in U.S. dollars per family member, so you can bribe your way out of the airport if necessary,” a Canadian business executive reported. “You keep open return tickets out of Jakarta. You keep provisions of one to two weeks for your house, and you keep a bag packed.”

  IMF and World Bank officials were at a loss to explain why the markets were reacting with such savage negativity to a program that was designed to exceed expectations. “I’m surprised, because I think this is a very strong program,” Aghevli said two days after the program’s announcement. “I think it may Just take time for the market to digest the news and realize the enormous significance of these reforms.” One theory was that currency traders and investors were skeptical that the sweeping measures would be implemented—not because Suharto had said or done anything in particular since January 15, but because his credibility had sunk so low. That interpretation, of course, pointed the finger at Suharto, though it also implied the Fund was pitifully insensitive to market sentiment by including so many structural measures that only undermined confidence.

  Nobody can discern with precision the motives of the thousands of people who were unloading the rupiah at the time. A look at news reports and investment analyses from January 15 and 16 shows that some foreign exchange analysts in the region were indeed questioning Suharto’s commitment to the promises he had made. Others cited political factors and concerns about social unrest that remained unaddressed; Suharto, after all, still didn’t have a clear successor, and if he were to die or be forced from office, the potential for bloodshed was high.

  But the most oft-cited and specific complaint about the IMF program was that it contained no hint of any plan for tackling a primary source of worry about the rupiah—the increasingly crippling foreign debt of Indonesian companies. In a comment echoed by a number of other market analysts, Manmindar Singh, a senior economist at Nomura Research Institute in Singapore, was quoted as follows by Dow Jones International News on January 15: “The downside of the reform is it is short of policy on how to resolve the problem of corporate debts. The market will not go anywhere as long as the issue remains unresolved.”

  Here, it might seem, lay one of the keys to pulling Indonesia out of its death spiral—taking steps that would ameliorate the corporate debt problem—and the obvious question is why the IMF sidestepped the matter in the January 15 program. Part of the answer is that the Fund, for all its expertise in macroeconomic policy, has few specialists in corporate finance. But more important, the issue posed thorny dilemmas that underscore the difficulty of coping on the fly with crises of globalized capital.

  The argument for taking action on the corporate debt issue was, in broad terms at least, the same as the argument for the deal that had saved Korea Just a few weeks before, on Christmas Eve 1997— namely, a self-fulfilling panic had taken hold. Everyone could see that most of Indonesia’s private companies and banks would be unable to obtain enough dollars to repay their foreign creditors what they owed in the months to come. For example, Indofood, the company controlled by Suharto crony Liem Sioe Liong, had borrowed hundreds of millions of dollars from abroad without hedging itself. The company was presumably in a position to repay its debt the previous summer when the rupiah was at 2,500 per dollar, but if the rupiah were to fall to 10,000, the amount of rupiah it needed for repayment would quadruple. The extraordinarily cheap value of the rupiah was aggravating fears of corporate insolvency, and vice versa. So unless the markets got some kind of assurance that debtors would be given time to work out their debts and avert cutoffs of credit, the panic would continue apace.

  The World Bank’s Cazenave had been raising this issue, as noted previously, and some IMF economists, Josh Felman in particular, were also arguing prior to January 15 that the subject had to be addressed. At the very least, Felman contended, the portion of the debts that Indonesian banks owed to foreign banks should be handled with a standstill similar to the one in Korea, because Indonesian banks, like the Korean ones, were suffering from a refusal by foreign creditors to roll over credit lines. This debt constituted less than half of the country’s obligations to foreigners, but it was arguably the most important part. A bank that has defaulted on its debt isn’t able to provide the kinds of services that keep the economy functioning, such as letters of credit, foreign exchange transactions, and so forth. If the High Command could use its muscle to help Korea get some relief from the pressure being exerted by foreign financial institutions, why couldn’t it do the same for Indonesia?

  But the majority sentiment within the Fund and the G-7 was against such action: Indonesian firms should sort out their own problems with their foreign creditors. In the first place, Indonesia was different from Korea because so much of its overseas debt consisted of obligations owed directly by companies such as Indofood rather than by banks. And saving those companies from their creditors would pose monumental moral-hazard problems. The Indonesian government, for example, could help the companies by guaranteeing payment of the additional debt burdens the companies faced as a result of the drop in the rupiah. But why reward such companies, especially when so many of them—presumably counting on being bailed out if the going got rough—had failed to hedge themselves? The cost to the Indonesian taxpayer would be both staggering and unjust.

  The U.S. government was particularly opposed to anything that resembled a bailout of Indonesian companies. “This was the third rail”—that is, an untouchable idea, said the Fed’s Ted Truman. “Can you imagine—having the Indonesian government take over obligations of private Indonesian corporations to foreign banks?”

  One other option, even more radical, was a government edict to halt the panicky outflow of funds and impose capital controls that would bar all payments abroad by Indonesian companies at least temporarily, until a longer-range plan could be developed to stabilize the economy. Some IMF staffers in Jakarta urged such a step around the time of the January 15 program, arguing that the country’s crisis had gone beyond conventional remedies. But the drawbacks were glaring, not the least of them the fact that Indonesia’s corrupt bureaucracy would allow a lot of money to escape anyway. At a meeting in early January, Stan Fischer told Fund economists that the leading shareholders—meaning first and foremost the United States—would never go along.

  The debate over what should have been done to save Indonesia continues to swirl today. But here’s the punch line: The IMF eventually did take measures (albeit limited ones) to address the private debt problem, and it also took a couple of other steps that it had been resisting, the most important being to reach agreement on a full guarantee of bank deposits to stem runs by depositors. The problem was, these corrective moves came after the failure of the January 15 program, and at that point, confidence in the country’s economy had been dealt a blow from which it would never recover. It must be added that Suharto made a bad situation worse; about a week after January 15, the Indonesian leader began dropping hints that he would choose B. J. Habibie, his technology minister, as his next vice president and presumed successor. That sent a strong signal Suharto was turning away from his reform pledges, since Habibie was a well-known economic nationalist whose government-backed project to build an aircraft had been among those targeted by the Fund.

  Perhaps the most overdue measure, a comprehensive
Indonesian government guarantee on bank deposits (set for a minimum of two years), was announced on January 27, 1998. The moral-hazard zealots at the Fund had been fighting this proposal since late 1997, but by this stage, the bank runs were so ruinous as to leave little room for debate. Later in the spring, the IMF would work out a plan that enabled Indonesian banks to reschedule their interbank loans from foreign banks, as the Korean banks had done. And at the same time as the deposit guarantee was initiated, the Fund agreed with the Indonesians to start a process aimed at rescheduling corporations’ foreign debts. (The corporate debt plan was by no means a miracle cure; in keeping with the concerns of U.S. officials and others, it was devoid of any government subsidy that would make it very attractive for Indonesian companies and their creditors to participate.)

  It is instructive to spin a small fantasy about how the Indonesian crisis might have worked out differently. Imagine what might have happened if the comprehensive deposit guarantee had been issued in, say, mid-November 1997, so that the bank runs would have been contained and Bank Indonesia would not have felt obliged to flood the banking system with cash. Suppose, too, that a plan for rescheduling the interbank debt of Indonesian banks had been implemented earlier in the crisis, along with something resembling the limited corporate debt scheme that was eventually adopted. Finally, suppose the IMF had insisted on fewer structural reform conditions in its Indonesia program.

  Would the rupiah still have crashed? If it hadn’t, would Suharto have manifested greater fidelity to the structural reforms—or would he have reneged on his promises anyway? Would a virtuous cycle have taken hold, or would a vicious one have continued?

  The virtuous-cycle fantasy may be Just that—a fantasy. Once the rupiah started to slide in earnest in late 1997, Indonesia’s economy may have been doomed, simply because fears of social and political unrest became so intense and so self-fulfilling. The wealthy ethnic Chinese who supported Suharto’s regime, and benefited from it, may have been impossible to restrain from moving their money overseas, because they were so spooked by concerns about the president’s mortality—his political mortality as well as his physical mortality.