In the first quarter of the reporting year, the monetary policy stance was directed to reigning in the robust domestic demand so as to maintain stability. The containment of domestic demand was in fact a preemptive measure in view of the strong expansion of bank credit, particularly to finance property projects and consumer products amid an influx of capital inflows, especially of short term. To this end, Bank Indonesia raised the statutory reserve requirement and imposed a limitation on lending to the property sector. These measures, combined with appreciation of the rupiah, had helped curb the inflation rate at a modest level of 5.11%.

Since July 1997, monetary situation changed dramatically as the rupiah came under pressure. To address this problem, up to August 1997 monetary policy was directed toward tightening domestic liquidity so as to ease the pressure on rupiah. The discount rates on SBIs for various maturities were raised with the highest was recorded for 1 month, namely from 11.12% to 30.00%. In addition, SBPU transaction, rediscount facility, and SBI on repo basis (repurchase agreement) were temporarily suspended. In the area of credit, Bank Indonesia tightened the expansion of liquidity credit either through rescheduling or postponing disbursement of large loans. The government also supported this move by transferring the placement of state enterprises’ funds amounting to Rp 3.4 trillion to SBIs.

To improve the effectiveness of monetary policy and the flexibilty of exchange rate, on July 11, 1997, Bank Indonesia widened the intervention band from 8% to 12% combined with intervention in foreign currency market through spot, forward, or swap transactions. The intervention in the short-term managed to resist further depreciation of the rupiah and helped tighten liquidity in the economy. However, with deteriorating monetary trends in South East region and higher speculative pressures, the exchange rate of rupiah started to weaken again. In view to secure foreign exchange reserves and make the monetary policy more effective, the Government, on August 14, 1997, phased out the intervention band and adopted a freely floating exchange rate system. Meanwhile, to resist speculative pressures on rupiah, Bank Indonesia restricted forward rupiah transaction between banks and non-residents. The maximum amount for one client was set at $5 million per bank, except for investment purposes and export-import activities.

As a result of the policies engaged in, monetary situation in September 1997 remained manageable. Exchange rate turbulence moderated after its large swings in the preceding month, while annual inflation rate up to August 1997 stayed at a low rate. Consequently, it gave a more room to the Government to mitigate the burden in the banking and real sectors. The high interest rate and the weakening rupiah exchange rate had weakened banking liquidity so that impeded credit expansion and worsened banking asset quality. In the real sector, the high interest and weakened exchange rate had constrained the economic activities. Hence, to improve economic resilience, the government in the Cabinet Meeting on September 3, 1997 introduced a policy package covering 10 measures of economic adjustments. Although the package was still aimed at stabilising macroeconomic conditions, it relied not only on monetary policy but also entailed other measures in the fiscal sector, banking sector, and capital market. The policies included liquidity easing in a gradual and prudent manner, in addition to improving the soundness of the financial system, particularly banking sector. The measures in the banking sector included providing liquidity support to viable banks that faced liquidity problem, encouraging merger and acquisition in the banking industry, and revoking business license for unviable banks.

In line with the 10 measures of economic adjustments, Bank Indonesia eased liquidity cautiously. SBI with one month maturity rate were lowered gradually to reach 20.00% per annum. Sound banks that possessed SBI were allowed to reuse the rediscount facility. Besides, Bank Indonesia also liquidated SBI of the state enterprises amounting to Rp5.7 trillion. To ease liquidity problem in the real sector, particularly the small-scale enterprises, Bank Indonesia resumed the application of SBPU facility for sound banks that has been tied with credit to small-scale enterprises. In addition, to lessen the negative impacts of the rupiah exchange rate crisis on the small-scale enterprises and to boost non-oil/gas export, Bank Indonesia allowed any credit expansion beyond the Annual Work Plan (RKT) provided it was a consequence of the rupiah exchange rate alteration. The excess of credit expansion was used to finance activities of small-scale enterprises, cooperatives, and non-oil/gas export.

Nonetheless, the crisis persisted with more severe negative impact beyond the previously expected. Market players responded negatively to the decline in interest rate and the ease of liquidity, resulting in a downward trend of rupiah exchange rate. The Government therefore set a sweeping agenda that covers not only macroeconomic stabilisation program through fiscal and monetary policies, but also reform program in the financial and real sectors. The program is technically and financially supported by multilateral agencies such as the IMF, the World Bank, and the ADB, as well as other bilateral creditors. The internationally supported program was confirmed in the signing of the economic restructuring program in November 1997.

The first step in the reform program in the banking industry was taken on November 1, 1997 when the Government revoked business license of 16 unviable banks. The measure that initially aimed at restoring confidence in the banking system was negatively responded. People withdrew a large amount of currency and transferred their funds from presumably unsound banks to sound banks. Consequently, a number of banks ran into liquidity problem that led to violations of the statutory reserve requirement. A number of banks even experienced negative balance in their accounts at Bank Indonesia. To preclude the domino effect on other banks with a systemic risk for the entire banking system, Bank Indonesia as lender of the last resort provided liquidity support to the problem banks. Up to December 1997, the liquidity support amounted to Rp62.9 trillion originating mainly from discount facility I, discount facility II, and the conversion of negative balance to special SBPUs with a value of Rp37 trillion.

Added to this liquidity problem was stronger segmentation in the interbank money market as reflected in the concentration of liquidity on few banks and the widened range of interbank rate between the highest and the lowest rate. Strong banks, like foreign banks, possessed ample liquidity as they received an influx of funds from the presumably unsound banks. To moderate segmentation, Bank Indonesia intervened directly in the interbank money market through open market operation. This measure was evidently effective in absorbing and redistributing excess liquidity to problem banks. It is noteworthy that direct rupiah intervention in the interbank money market is a more flexible instrument because its discount rate is adaptable to changes in the money market.

To moderate the rupiah exchange rate fluctuations and sustain the desired rate, during September - December 1997 Bank Indonesia had added the supply of dollar to domestic markets through intervention in foreign currency market. That addition depleted net foreign assets of Bank Indonesia by $7.47 billion. Besides, Bank Indonesia lowered the statutory reserve requirement for foreign currency from 5% to 3%. Bank Indonesia also provided rediscount facility on export drafts for exporters and priority exporters in a post-shipment condition and rediscount facility on estimated export draft for priority exporters in a pre-shipment condition. A side from the above sources, the Government augmented the dollar supply through the support from multilateral agencies consisting of the $10 billion standby loan from the IMF, $4.5 billion from the World Bank, and $3.5 billion from the ADB. Up to the end of the reporting year, the IMF has released $3 billion in November 1997.

Up to closing the year of 1997, however, the rupiah exchange rate continued to weaken to Rp4,650 per dollar because of the increased demand for dollar to meet the corporate external liabilities and speculative purposes in the foreign currency market.

In 1998, monetary conditions worsened. The erosion of confidence in the banking system and the increased demand for currencies to welcome holidays that came in within a short time span contributed to a massive withdrawal of money from the banking system. As a consequence, currency in circulation increased dramatically. Meanwhile, shortages of basic commodities due to prolonged drought and increasingly expensive prices of of imported raw material and panic buying brought about higher inflation. In January inflation rate soared to 6.88%, while exchange rate had been traded at Rp16,000 per dollar.

To cope with the worsened crisis, the Government expedited and broadened the coverage of stabilisation program and economic reform by the signing of the letter of intent with the IMF on January 15, 1998. In the monetary policy area, the Government strove to regaining confidence in the banking system and stabilising the rupiah at a level that was compatible with economic fundamentals through tightening economic liquidity. To restore confidence in the banking system, the Government as of January 27, 1998 has fully guaranted all depositors and creditors of all locally incorporated banks. The guarantee scheme covers all private-owned commercial banks, joint-venture banks, and state-owned banks. In addition, the Government set up IBRA (Indonesian Bank Restructuring Agency) to strengthen soundness of the banking system, restructure the banking industry, and implement the government guarantee scheme.

Besides, to encourage people to put their money back in the national banking system, the SBI rates were raised gradually. Its purpose was to make real interest rate positive to attract foreign capital inflow so as to add to the supply of foreign external reserves and strengthen the rupiah exchange rate. On January 27, 1998 SBI rate increased with the highest SBI rate of 22.0% for one month. On March 23, 1998, the SBI interest rate was elevated again to 45% for one month.