The Causes, Effects and Lessons of the 1997 East
Asian Financial Crisis
April 9, 2007
FSPP 556: Macroeconomics
Professor Kathryn Dominguez
Indonesia’s Economy at a glance:
Introduction GDP (adjusted for PPP): $935 billion
Following its independence in 1945, the Indonesia (2006 est.)
economy deteriorated drastically as a result of political instability, GDP (real growth rate): 5.4%
a young inexperienced government, and ill-disciplined economic GDP (per capita): $3,800
nationalism. However, the New Order administration in the
Population below poverty line: 17.8%
1960s, brought about a new degree of discipline to economic
policy that quickly brought inflation down, managed foreign debt, Source: CIA Factbook
but more importantly, attracted foreign investment through
financial liberalization. As massive inflows of foreign investment poured into the country, problems
soon arose with regulation and oversight. These structural weaknesses created instability and
ultimately multiplied the effects of the Asian Financial Crisis in 1997. With strong encouragement of
the IMF, Indonesia adopted a set of policies to protect currency values and penalize insolvent
companies, in order to restore investor and creditor confidence in the country. Despite assistance
from the International Monetary Fund, the Crisis devastated the Indonesian economy and brought on
massive social unrest.
This paper consists of six parts. We intend to analyze pre, during, and post-crisis trends
utilizing such macroeconomic models as the Mundell-Fleming model, the IS-LM model, and the
open economy model for calculating exchange rates. First we provide a brief overview of the Asian
Financial Crisis. The second part of the paper analyzes why the crisis happened; moreover, what
policies lead to the crisis. Third, we provide an in depth examination of Indonesia’s response to the
crisis. Forth, we evaluate what went wrong with Indonesia’s macroeconomic response to the crisis
through the models. Fifth, we examine what occurred in the aftermath of the crisis. The final part of
this paper analyzes the future steps and outlook for Indonesia.
The Asian Financial Crisis of 1997
During the late 1980s and early 1990s, international investors became enamored by the
potential of emerging markets in Asia, particularly in Indonesia. As a result investment flowed into
Indonesia during this period, particularly into a rapidly developing export-oriented manufacturing
sector, and the Indonesian economy grew over 7% annually. (Appendix A)
Moreover, with low US interest rates and slowed economic growth in Japan, foreign
investors increasingly poured capital into East Asia. Other East Asian countries like Thailand,
Malaysia, South Korea, and the Philippines also experienced substantial inflows of foreign capital.
However, the attractiveness of these investment opportunities began to weaken around the mid-
nineties, when the US Federal Reserve began raising interest rates; thus, the rising value of the dollar
made investing within the US more attractive. Furthermore, since the rupiah, Indonesia national
currency, was pegged to the dollar, its value decrease, as did the competitiveness of their exports.
In early 1997, increased skepticism regarding Thailand’s economy led to speculation of a
potential devaluation of the Thai currency (the baht). Investors such as George Soros began to attack
the currency, buying baht with the goal of “selling short.” Moreover, as capital began to flee the
country, Thai citizens increasingly began to fear the devaluation as well, which further depreciated
foreign reserves. Upon exhausting its reserves, the Thai government was forced to float the baht on
July 2, 1997, leading to an immediate devaluation of 15-20%.i
Thailand’s devaluation induced a panic among investors. As a result of this growing
speculation, foreign investors began calling in for their short-term loans and selling their
investments. Domestic residents, who had also feared the devaluation, also began to send their
capital abroad. This situation continued to perpetuate until it finally reached Indonesia.
Under the IS-LM Model we can observe how the crisis developed.
Real *Note: The slope
(steepness) of the IS (and
LM) curve depends on
how sensitive output
Equilibrium (money demand) is to
changes in the interest
3 Expected Deflation
(1) Investors expect devaluation of the rupiah, due the increasing value of the US dollar and
what occurred in Thailand.
(2) Reluctance to borrow: because loans will have to be repaid in more valuable dollars the IS
curve shifts inwards.
(3) Fall in invest: depresses planned expenditure, which in turn depresses income from Y1 to Y2
(4) The fall in income, which decreases money demanded
(5) The reduced demand in money reduces the nominal interest rate
(6) The nominal interest rate falls below the expected deflation, thus the real interest rate raises.
Causes of the East Asian Financial Crisis
In the aftermath of the crisis, economists and politicians alike struggled to identify its
causes. According to an IMF report published the year following the crisis, several factors, both
country-specific and international, were to blame. At the domestic level, large external deficits,
inflated property and stock market values, a build-up of overheating pressures, and unreasonable
expectations on returns, stemming from a lack of transparency and availability of credible data, all
contributed to the crisis. In addition, poor corporate governance and inadequate oversight of
financial systems led to corruption, the concentration of wealth in the hands of a few politically-
connected banks, and an increase in political and high-risk lending.ii By July 1997, nonperforming
loans (i.e. those which are never repaid) accounted for over 15% of all domestic loans. (In contrast,
the U.S. had a 1% rate of nonperformance.)iii Furthermore, both Indonesian banks and private firms
were dependent on loans rather than equity as their primary form of finance, and by 1998 they had
accrued over $82 billion in debt, 88% of which was in the form of loans. By comparison, the U.S.
holds 22% of its debt in the form of loans.
Compounding the problem of high-risk lending was the short-term nature of the borrowing.
The optimism of investors in the early 1990s led to a steady increase in the number of “roll over”
loans issued, loans which were taken out to cover old loans, ad infinitum. At the end of 1996, 62%
of all loans taken out by Indonesian firms or banks had a maturity of one year or less.iv Because
those loans could be called in at any time, debtors were highly vulnerable to shifts in lender
sentiment and investment preferences. One factor altering these preferences was the exchange rate.
Banks and firms borrowed in dollars and repaid in rupiah, a system which worked well unless the
rupiah were to devalue, in which case lenders would face an increase in their debt burden. The high
levels of external borrowing created great exposure to foreign exchange risk for both private firms
and the government.v
This risk was underestimated in the 1980s and early 1990s, when investment poured into the
emerging economies of Southeast Asia. However, by the mid-1990s, after the Mexican peso crisis
of 1994, lenders were wary of developing countries and started to pay more attention to the riskiness
of investing in the Asian Tigers. Perhaps the greatest factor leading to the crisis was the devaluation
of the rupiah, which exacerbated the issues related to uncertainty in investment. The depreciation
was a result of rising U.S. interest rates, and dealt a crushing blow to the economy of Indonesia by
decreasing investment in the region, lowering the purchasing power of Indonesia on world markets
and driving up debt. One final international factor that may have contributed to the crisis was
increasing competition from China in regards to the exporting of goods to the West and the attracting
of capital and manufacturing contracts, sectors which were at the heart of the Indonesian economy.vi
Response to the crisis
As the Thai baht came under attack in the summer of 1997, the Indonesian government took
a number of steps to prevent the devaluation of its currency, maintain a relatively stable exchange
rate and stop investment from fleeing the country by keeping interest rates high. On July 11, 1997
the monetary authority, the Bank Indonesia (BI), took its first step towards these goals by widened
the pegged exchange trading band from 8% to 12%. However, the strategy failed to maintain the
value of the money and the rupiah began a steep depreciation ten days later. In response BI raised
interest rates from 12% to 13.5% on July 23rd to support the rupiah, but that policy also failed.vii As a
last-ditch effort, BI decided on August 14th to float the currency and simultaneously raise short-term
rupiah interest rates in order to attract rupiah deposits and stabilize the currency, while the fiscal
authority cut non-essential spending. This plan backfired due to the severe tightening of liquidity,
which caused interest rates to overshoot their goal and jump to 44.5%, and the value of the rupiah to
decline by more than 33%.viii
A week later the government adopted a five-point plan to deal with the crisis, a policy that
tried to i) stabilize the rupiah at a new equilibrium level, ii) strengthen fiscal policies and fiscal
consolidation, iii) reduce the current account deficit, iv) support the banking sector and finally, v)
reassure the private sector about the stability of the economy. For a few weeks the program
appeared to work, but the currency crisis intensified in November of 1997, when the floating
exchange rate dropped an additional 42% to 18000 rupiah/dollar as more investors fled the country
after seeing corporate earnings reports, which reflected the devaluations from the summer. At this
point the IMF intervened.ix
The IMF and the government of Indonesia signed an emergency lending agreement in
November of 1997, the goal of which was to “restore investor and creditor confidence in the
country’s fiscal solvency by protecting currency values and penalizing insolvent companies.”x The
Reform and Stabilization Program, as it was known, was comprised of four prongs: i) a package of
loans from the IMF to BI, ii) an agreement to maintain a balanced budget or surplus, maintain high
nominal interest rates and restrict domestic credit to keep exchange rates stable, iii) a promise to
undertake drastic restructuring of the financial markets and iv) a pledge to adopt “good governance”
reforms and improve oversight of corporations.xi Unfortunately, rather than restore confidence, these
reforms only created uncertainty about the fate of the banking system, the effectiveness of the
government at reforming itself, and the solvency of remaining investments.xii
These fears were realized in early 1998, when the Indonesian government presented its
budge for the upcoming fiscal year. Not only did it fail to include the 1% surplus requested by the
IMF, it proposed an expansion in government spending, drawing the country into deficit instead.
This plan was publicly denounced by the IMF, which called it a sign that Indonesia was not serious
about reforming, a statement which in turn further erode investor confidence.xiii However, due to the
currency depreciation, the increase in government expenditure was nominal and in real terms, the
proposal was a contraction in fiscal policy, a fact ignored by the IMF. A few months later, in an
attempt to appease the IMF, the Suharto government agreed to a plan to reform the banking sector by
instating a government guarantee of all debts in domestic banks, creating a regulatory body (the
Indonesian Bank Restructuring Agency) to oversee all banking transactions, and establishing a
currency board to help regulate inflation. In exchange, the IMF modified the policies it
recommended for Indonesia’s recovery and made them more reasonable. Trying to minimize the
budget deficit was the new goal, rather than aiming for a budget surplus. Other changes included
international forgiveness on certain debts, a greater focus on long term structural changes in the
banking system and a government guarantee on all domestic bank liabilities.xiv When in April 1998
the IMF decided not to provide the second round of assistance it had promised, the banking reform
plan was dropped, and the new guidelines ignored.xv
By March 1998 the exchange rate had somewhat stabilized at a rate of about 10,000
rupiah/dollar. (Prior to the crisis the rate was closer to 2,000 rupiah/dollar.) Slowly investment
began to flow back into the country and firms reopened, but over the first year of the crisis real GDP
dropped by 17.4%, inflation rates reached 78%, the value of the stock market dropped by 83% and
more than 20 million people lost their jobs, leading to 13.2% unemployment.xvi,xvii Although the other
victims of the 1997 crisis suffered major blows to their economies as well, none fared as badly as
Indonesia. After using the Mundell-Fleming model to interpret the actions taken in response to the
crisis, we will look at the errors in judgment made by both the IMF and Indonesian government, the
reasons their policies failed, and what they could have done differently to avoid such dramatic
setbacks to the country.
Interpreting the Response Through the IS-LM Model
Indonesia remained steadfast about maintaining a fixed exchange rate. However, in July
1997, Indonesia had no choice but to float the exchange rate. As a result, they continuously
attempted to raise the interest rate in order to restore and establish foreign investor confidence. How
does this work economically? According to the Mundell-Fleming model (IS-LM-BP) model we
would expect that:
As described up above, the speculation of the devaluation of the rupiah would lead to
decreased investment. Furthermore, during a time of crisis we would expect consumption to
decrease and a reduction in government expenditure. Looking at our open economy IS curve:
(1) If Y= C(Y-T)+ I(r)+ G+NX(e)
While holding NX(e) constant, a decrease in C, I(r), and G would lead to a inward shift in the IS
curve, from IS0 to IS1. Due to the decreased investment, the Indonesian government artificially
attempts to keep the interest rates high in order to restore confidence in foreign investment.
Moreover, now they are underneath the original balance of payments (BP0) and current in deficit.
Thus, in order to increase the interest rates and get out of deficit, we would expect the government to
contract the money supply (moving to R1 and BP1)
(2) The government succeeds in raising the interest rate. However, two major problems
a)The GDP decreases substantially
b)While the interest rates increases, foreign investors still are cautious about investing
in the country.
(3) The crisis worsens, investment deteriorates, consumption and government expenditure
would continue to decrease; thus, the IS curve once again shifts inward towards IS2.
(4) The Indonesian government continues to artificially increase the interest rates. Thus,
they contract the money supply once again (moving to R2 and BP2)
(5) Investors are still not enticed to invest with the even higher interest rates. Again, GDP
falls and this process continues until the government realized that maintaining a fixed
exchange rate was not going to work.
Interest Rate LM2
*Note: There was free
flow of capital within
5 Indonesia, thus, the
flat BP curves.
6 R2 BP2
3 R0 BP0
Y3 Y2 Y0 Y= GDP
VI. Why the IMF Programs Failed
In 1998, less than nine months after the IMF pulled its support out of Indonesia, Jeffrey Sachs and
Steven Radelet published a paper arguing that while bureaucratic issues within the country may have
contributed to the failure of the IMF programs, the international authority’s policies and attitudes
were really to blame for the sluggishness of Indonesia’s recovery. They cited seven reasons for the
IMF’s ineffectiveness, which are listed below.
• The IMF can not rally market confidence, because its mere presence in a country is a symbol
of domestic economic failure and instability.
• Instead of reassuring investors that the problems of Indonesia were only temporarily, the
IMF announced to the world that there were “deep fundamental weaknesses” in the financial
structures of the country, which were unlikely to be reformed quickly.
• The IMF believed, incorrectly, that crackdowns on inefficient markets and corrupt banks
would reassure creditors of the solvency of remaining markets and banks and encourage
them to roll-over short-term loans.
• The IMF advocated a contraction in fiscal policy, a plan which runs counter to both the
Keynesian theory that a government must expand during crisis, and empirical evidence from
the experience of the U.S. during the Great Depression.
• The loan packages offered by the IMF were not large enough to ease Indonesia’s
considerable debt burden and “provided only a weak shadow of a lender of last resort.”
• The agreements signed between the IMF and Indonesia stipulated reforms in a wide range of
policies, including demonopolization, trade liberalization and privatization. While some
reforms were germane to the crisis, most were not and instead ate up valuable government
time, money and resource, which could have been spent solving the problems around the
exchange rate, interest rate and inflation.
• The initial loan programs and agreements were not made public, as per IMF protocol. This
secrecy and uncertainty further eroded investor confidence and deterred investment to the
countries signing the agreements.xviii
Apart from these misjudgments in policy, the IMF also failed to deliver on its promises of
financial assistance. By March 1998 only $3 billion of $40 billion promised by the IMF to
Indonesia had been disbursed.xix Compounding the problems associated with the IMF were the
obstacles to reform and recovery within the country. Wide-spread corruption and cronyism
prevented important issues related to banking regulation, trade policy and fiscal policy from being
discussed publicly. For example, political pressures prevented BI from carrying out IMF
recommendations and closing insolvent banks, many of which were connected to the Suharto
family.xx Although Suharto was eventually forced to step down in May 1998 and many of his family
members also resigned from government positions, fraud and bribery remain problems in Indonesia
and continue to impair economic growth and political progress.
IV. What went wrong?
Even after floating the exchange rate, Indonesia was still unable to stabilize the exchange
rates. Utilizing the of principles of macroeconomics we would expect that:
Exchange S – I (r0) S – I (r1)
Nx0 Nx1 NX
(1) As we know, the supply of net capital outflow is: S-I(r). In order to keep this model
simple, let us assume that savings remains constant. It was Indonesia intent to raise
interest rates (r) to entice investment.
(2) As discussed up, skepticism was strong and investment continued to decline. The
Indonesian government continues to increase the interest rate even higher. As a result,
there is a reduction in the exchange rate.
(3) Due to the lower exchange the currency depreciated. On one hand this made Indonesian
goods cheap, thus, increasing net exports of goods. However, on the other hand, it did
not increase investment, nor government expenditure or consumption.
What policies should have Indonesian implemented? Had Indonesia followed the Keynesian Model,
they would have likely observed better outcomes.
Y0 Y1 Y= Output
(1) Looking at the model, if the IS curve is: Y= C(Y-T)+ I(r)+ G+NX(e), had the
Indonesia government increased the government expenditure than it would have
shifted the IS curve outward.
(2) As a result, the interest rate would have increased.
(3) Furthermore, this would have also increased GDP, instead of lowering it.
Potential Next Steps
Although Indonesia has made substantial progress in the past ten years, the country still
faces a high level of poverty, precarious inflation levels, and a robust infrastructure needed to
support significant development.xxi As a result, several policies Indonesia might consider to help
bolster their economy include:
1. Continue to improve the Bank of Indonesia’s transparency, independence,
accountability, and credibilityxxii
2. In order to maintain market confidence and attract additional foreign investment,
continue to invest in local programs that create a more stable infrastructure and aid
in the development of human capital
3. Increase tax revenuexxiii
4. Continue to reduce the debt to GDP ratioxxiv
Where is Indonesia Today
Almost ten years post-crisis, Indonesia has made two key changes that aid in the country’s
economic growth and stability. First, following the resignation of Suharto, Indonesia has developed
an effective, democratic government under the rule of current president Susilo Bambang
Yudhoyono.xxv This change has reduced the high levels of corruption that were present under
Suharto’s regime and have re-focused government priorities to work towards providing basic
necessities such as water and education for Indonesian residents.xxvi
Second, these changes have fostered a climate that supports sound macroeconomic policies
that have helped to create a growing economy. These include reducing the government’s debt ratio,
creating a more accountable banking system and improved fiscal management, and creating a
favorable climate for investors. Currently, the country is enjoying 5-6 percent annual economic
growth, an increase in the country’s reserves up to US$30 billion, and a decrease in the public debt
to GDP ratio to below 40%.xxvii
Overall Indonesia has made a strong recovery since the crisis, especially given the lack of
help it received from the IMF in 1997/1998. However vulnerabilities still exist in the government
and financial sectors, vulnerabilities which much be monitored by both domestic and international
agencies to ensure that the Asian Financial Crisis of 1997 remains a solitary incident of the past, and
not the first in a series of reoccurring currency emergencies.
Shelandra Sharma, “The Indonesian Financial Crisis: From Banking Crisis to Financial sector Reforms 1997-2000,” April
Mari Pangestu and Mangi Habir, “The Boom, Bust, Restructuring of Indonesian Banks,” (2002).
Nicholas Kristof and David E. Sanger, “How US Wooed Asia to Let the Cash Flow In,” New York Times, 16 February
Bank for International Settlements, www.bis.org
“The Asian Crisis: Causes and Cures,” Finance and Development, June 1998, Volume 35, No 2.
Shelandra Sharma, “The Indonesian Financial Crisis: From Banking Crisis to Financial sector Reforms 1997-2000,”
International Financial Statistics, http://ifs.apdi.net/imf/ImfBrowser.aspx
Sharma (April 2001).
Mohammad Yasin, “Economic Crisis and Financial Reform in Indonesia,” Asia Forum (1999).
Steven Radelet and Jeffrey Sachs, “The East Asian Financial Crisis: Diagnosis, Remedies, Prospects,” Brookings paper
on economic activity (1998).
Sharma (April 2001).
Radelet and Sachs (1998).
Leonardo Martinez-Diaz, “Pathways through Financial Crisis: Indonesia,” Global Governance 12 (2006).
Islamic Development Bank, “1997 Economic Highlights” http://www.idb-uif.org/Economic.htm
Zmag.org, “The Latest Bust,” http://www.zmag.org/Instructionals/GlobalEcon/id4_m.htm
Radelet and Sachs (1998).
Radelet and Sachs (1998).
“Indonesia: Monetary Transparency.” Oxford Analytica. November 2006, http://www.calpers.ca.gov/eip-
“Indonesia: Recovery at a Crossroads,” Embassy of the United States: Jakarta, Indonesia. 6 March 2001,
“Progress With a Backdrop of Volcanoes,” The Economist, 25 May 2006.
Timothy Harcourt, “Indonesia’s Recovery: From Suharto to SBY,” Austrade.gov, 14 December 2006,
“Global Corruption Report 2004,” Transparency International, www.trasparency.org
Timothy Harcourt, “Indonesia’s Recovery: From Suharto to SBY,” Austrade.gov, 14 December 2006,