Institutional Failure: Indonesian Economy 1997
Spotting Weakness
An important element in anticipating security price trends is understanding the strengths and weaknesses of institutional structures that support current capital flows.
Level One and Level Two analysis use flow of funds accounts and knowledge of history, sociology, and operations of market institutions to explain market trends.
We should remain alert for systemic weaknesses that may trigger structural change.
During this analysis, we should remain alert for systemic weaknesses that may trigger structural change in security markets.
To significantly effect prices, weak points must be relevant to the larger sectors.
A sharp reduction in the U.S. trade deficit could weaken bond prices, but a drop of the same percentage in equity issues by closed-end funds might be hardly noticed.
In lesson 25 we mentioned the possibility that the ethics and morality of buybacks might presage a market change, but other types of weakness may also influence markets.
Generalized Institutional Failure
History provides many examples of generalized institutional failure.
To mention a few:
- The reversal of progress of British imperialism and 19th century globalization as the result of extraordinary costs of World War I;
- The collapse of the U.S. savings and loan industry as a result of deregulation of interest rates;
- The collapse of the Brazilian economy in the 1980s and the end of the 'Brazilian Miracle' as a result of abandonment of foreign exchange control discipline;
- The prolonged U.S. Depression of the 1930s as a result of extraordinarily high taxes and tariffs, and government attacks on private property and capitalism.
There still is no consensus on what caused the Great Depression of the 1930sThe institutional collapses of which we speak are not the fluctuations of business cycles, nor failures of single institutions, such as Barings or Enron, but rather massive shifts effecting millions of people, based on fundamental flaws in the system.
Uncertainty About Economic Crises
Major failures of economic systems are rarely repeated in exactly the same way and there is often little consensus as to precise causes of a disaster.
Politics, the rewriting of history, and efforts to save reputations, often conceal truth, even after many years.
The causes of the Great Depression are still debated.
For example, the causes of the Great Depression of the 1930s are still debated.
In lesson 25, we discussed the relationship between the trade deficit and bond prices. From the articles on this subject, you will see that anything that disrupts patterns of global trade, such as a terror attack on the United States, could have devastating effects on U.S. securities markets.
However, this view of the trade deficit was not common wisdom in 2004.
The collapse of the Indonesian economy in 1997 is an example of structural weakness and shows how flaws may be overlooked by financial leaders and economists.
There are are lessons for all countries from this case.
The Collapse of the Indonesian Economy (1997)
In Indonesia, statistics published by the central bank (Bank Indonesia) showed clearly in 1997 that the banking system had an over-hanging dollar debt that would balloon out of control and throw the country into insolvency if the Rupiah were to decline sharply against the dollar.
A pattern of using short-term dollar loans for long-term capital needs had been apparent.
A pattern of using short-term dollar loans for long-term capital needs had been apparent for a decade as foreign banks aggressively sought to improve current earnings by putting loans to Indonesian businesses on their books.
In many cases, borrowers had no connection with the export market nor any means of earning dollars to repay dollar debt.
Many Indonesian businesses had come to depend upon renewal of dollar loans to stay in business.
This dollar liability was largely unhedged.
Top officials should have understood the absolute need to defend the Rupiah against devaluation at all costs because devaluation of the Rupiah would automatically increase the debt of Indonesian companies, making hundreds of large Indonesia companies and banks insolvent.
Unfortunately, neither the Minister of Finance, the governor of Bank Indonesia, the officials at the International Monetary Fund, or the World Bank, or the U.S. Treasury, or most international private bankers, seemed to be aware of this easily understood but extremely perilous situation.
On August 14, 2020, Sudradjad Djiwandono, the governor of Bank Indonesia, announced to a conference of almost one thousand bankers and businessmen in Jakarta that the government would allow the Rupiah to float against the dollar.
This policy was supported by the IMF and was seen as a way to avoid squandering currency reserves in a futile attempt to tie the Rupiah to the dollar.
The Indonesian crisis could have been avoided in economists had understood the fatal weaknesses in the system.
Some in the audience understood what this really meant, but most did not.
The Rupiah continued to weaken, but only slowly at first, for relatively few grasped the seriousness of the situation.
By the time the dollar-debt problem was generally known, it was too late — the Rupiah had fallen precipitously and the economy had spun out of control.
Events had been triggered that were to lead to the fall of the thirty-year Soeharto government; riots, rape, mayhem, and death; unemployment, increased poverty, and interruption of the education of children; multi-billion dollar losses, and one of the worst depressions of the 20th century.
The debt crisis of 1997 brought hard times to millions of Indonesians.All of this could have been avoided if economists and central bankers had understood the simple but fatal weaknesses in the system and had had the commonsense and gumption to take rapid, drastic measures in time to save Indonesian banks and industry.
An excellent account of the Asian financial crisis is in Paul Blustein's 'The Chastening'.
Further backgound on Indonesia can be found in Theodore Friend's 'Indonesian Destinies' and M.C. Ricklef's, 'A History of Modern Indonesia.'
Before proceeding, check your progress:
Self-Test
Examples of generalized failure of capital market institutions include:
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The primary cause of the 1997 Indonesian crisis was:
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The Indonesian crisis of 1997 could have been avoided if:
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