Explaining the Twin Crises in Indonesia

The co-existence of the ‘twin’ banking and currency crises in emerging market economies has raised concerns regarding the underlying causes and potential remedies. Literatures suggest that there are at least three major approaches that could be used to explain the phenomenon: the microeconomic perspective which emphasizes the role of asymmetric information problems in the banking sector, the macroeconomics perspectives that link the financial liberalization with the banking sector risky behaviors, and the new institutional perspectives incorporating political and financial institutions into the analysis of crisis. Using these frameworks to analyze the twin crises in Indonesia during the 1997-2000 periods, it is suggested that the crises are rooted in and could be well-explained by the asymmetric information model. Although the other models also influence the co-existence of banking and currency crises, it was the asymmetric information problems before and during the crises combined with political turmoil which magnified the contagion effect of the currency crisis in the neighboring countries to the Indonesian economy. Prior to the crises, moral hazard and adverse selection problems both in economic and political fields have significantly contributed to weak micro banking fundamental in the Indonesian banking system. High non-performing loans and weaknesses in the prudential regulation were also evident. Similarly, the post crises experiences demonstrated that uncertainty regarding the economic reform programs and political stability had undermined market confidence, triggered bank panics and worsened currency crisis. Findings of this study are expected to increase understanding on the determinants of twin crises as well as to provide valuable lessons in managing and maintaining robust financial sector in Indonesia.