Indonesia, once one of Asia's most powerful economies, has been hit exceptionally hard by the economic crisis that has crippled the region. Since the summer of 1997, Indonesia's currency, the rupiah, has lost 80 percent of its value. Economics correspondent Paul Solman examines the reasons behind the rupiah's decline.
PAUL SOLMAN: It's been one of the most unexpected features of the unexpected Asian economic crisis: the plunge of Indonesia's currency--the Rupiah--an especially stunning event in light of the Indonesian economy's solid track record. Fred Bergsten has advised various Asian governments, including long-time ruler President Suharto's.
Indonesia's economic crisis.
FRED BERGSTEN : Indonesia had been one of the most successful economies in the world for almost 30 years. It had grown at an average of over 7 percent literally for three decades. The World Bank said it had reduced poverty better than any country in the world, from about 70 percent of the country when Suharto took over, to less than 20 percent before the crisis broke. It was a big success story.
PAUL SOLMAN: Part of the success: euphoric foreign investment in Indonesian stocks, bonds and real estate. It helped fuel growth in the 1990's. But in the summer of '97, it became clear that Indonesian investments weren't paying off as advertised, and foreign investors started pulling their money out of the country. A booming economy was suddenly thrust into reverse. Perhaps the most dramatic outcome:
Indonesia's currency--the rupiah--lost 80 percent of its value within months.
FRED BERGSTEN: If our currency dropped as much as the Indonesian currency, which is 80 percent, it means that somebody who was worth a million dollars six months ago would now be worth two hundred thousand dollars. He would have lost 80 percent of his assets; his purchasing power would be down that much; the whole country would be incredibly worse off.
Explaining "supply and demand".
PAUL SOLMAN: So much worse off, in fact, that, in Indonesia, there has been looting and price rioting throughout the country. Now, a key goal of this story is to explain how a currency actually falls. We might have gone to Indonesia itself for this, but have taken the cheaper route: bringing Indonesia here to our studio in Washington. Okay, that's downtown Jakarta. And if we could have a river market, please. They're selling food, including their famed spices, so we thought we would too, to remind you how the price of anything is determined: by "supply and demand." You know the drill: a lot of folks want my peppers here? More demand, meaning I can charge more for them. Same thing with lower supply: fewer peppers on the market, and, all else 
equal, a higher price. Of course, if demand drops, the price tends to drop--as it does when the supply surges: a peck of peppers, and each of the little pepper-uppers is generally worth less. Look, the point of all this: it's just the same with currency. Supply and demand determine the market value of American or Indonesian peppers, America, or Indonesian currency. When lots of foreigners, want to buy stuff or invest in Indonesia, ultimately, they need rupiah to buy everything from food--to buildings--there's a waterfront hotel just out of the frame there--to Indonesian stocks and bonds. And that's why, in the harbor back behind me, 
as well as all over the country, there are currency exchanges for converting foreign money into local. Since a lot of foreigners did want to buy stuff or invest in Indonesia, for years, they traded their currencies for rupiah and foreign demand helped drive up the exchange value--the price of the rupiah.
PAUL SOLMAN: Is it really as simple as that?
FRED BERGSTEN: If foreigners want to buy Indonesian products, they essentially buy Indonesian currency to pay for the products. So if Indonesia is exporting a lot, that will drive up the value of the rupiah.
PAUL SOLMAN: So will foreign investment. And that's what happened when Indonesia's economy was cooking. But when foreigners started pulling out, that meant unloading their rupiah-denominated investments--in essence, unloading rupiah. And when that happens, locals with money often follow suit. Economist Richard Rahn.
RICHARD RAHN: Those people of accumulated wealth in Indonesia, they suddenly worry about the stability of their own government. That means they want to get rid of their domestic currency, they want dollars because they view the dollar as stable, so they sell their domestic currency, they buy dollars, which causes the price of dollars to rise a little bit, but really causes the price of their domestic currency to fall because people don't want it.
PAUL SOLMAN: What happened is that once foreigners and then Indonesians actually started selling their investments in rupiahs, the process fed on itself. As people saw the rupiah drop, they got scared it would drop further, and ran to the stores with the actual currency to buy goods before prices rose. Firms with loans in dollars suddenly had to come up with more and more rupiah to pay them off. The country was awash in its own money, which fewer and fewer folks wanted. As they turned desperate, panic spread. In short, the worst thing that can happen to a currency had happened: people had lost faith in it.
RICHARD RAHN: Well, it's like a classic bank run, and if you figure the whole county is one bank, now, a bank run occurs when people do not 
believe the bank has enough money in it to take care of all the depositors' claims. So everybody rushes down to the bank, hoping to withdraw their money before the other guys do, so they know some people are going to be left out. And, essentially, this has happened to the country.
PAUL SOLMAN: All right, we've tried to explain the currency collapse. But what can you do about it? The International Monetary Fund and the Clinton administration have been pushing a now-familiar program: economic reform in order to restore faith in the rupiah.
Restoring confidence in the rupiah.
FRED BERGSTEN: The Indonesians had to restore confidence in their currency, and that required three things: they had to stabilize their banking system, which people had lost confidence in; they had to change their corporate governance, get rid of crony capitalism, bad use of money; and they had to stabilize their political system because people were wondering about the future of President Suharto and the whole governability of this huge country.
PAUL SOLMAN: To restore confidence, Suharto agreed to the IMF demands, which included reforms such as balancing the budget, cutting off-budget government spending, giving the central bank autonomy, decreasing the immense economic power of Suharto's family and cronies. In return, he would get a $43 billion bailout. That sort of quid pro quo is the orthodox approach these days. But, not everyone agrees with it. In fact, an alternate--some would say "radical"-- proposal is to create a so-called "currency board." We've cobbled together our own model of one. Basically,
a currency board is a government body that replaces a country's central 
bank. Its sole job is to preserve the currency's value and discipline a government so it won't print too much money. In practice, it's very simple. The board fixes the value of the rupiah to a measure of value people trust, like the dollar. It then supports the exchange rate by buying up any rupiah offered for sale. It pays for the rupiah with its reserves of dollars, or other valuable currencies, or gold. And that's all it does. Economist Richard Rahn.
RICHARD RAHN: And as long as the people are satisfied that the currency board has 100 percent reserve in foreign currency, then they're happy to hold the local currency because they know they can always go in and get the foreign currency if they really want it. And if you know you can do it, then you don't bother.
PAUL SOLMAN: It may sound good. And currency boards are in place in Argentina, Hong Kong, Bulgaria, and a number of other countries. But, says Fred Bergsten, the discipline comes at a price: a country--in this 
case Indonesia--can no longer stimulate its economy the way the U.S. Federal Reserve, say, does ours. Instead, Indonesia may be forced to offer high interest rates as a payoff to lure foreigners back into rupiah. And that's nasty medicine.
FRED BERGSTEN: The Indonesians will not be willing to subordinate every other goal of economic policy to maintaining the currency board. They'd have to be willing to let interest rates go to 50 percent, 100 percent, whatever necessary. They'd have to let unemployment go up to 15, 20 percent, even more perhaps, to maintain the exchange rate with the dollar; they won't do it.
PAUL SOLMAN: Won't raise interest rates so high, that is, as to threaten sending an already crippled economy into outright depression, thus, risking further social unrest. The IMF and President Clinton agree on this. When President Suharto seemed about to adopt a currency board, they pressured him not to. And this weekend the Clinton administration is sending former Vice President Walter Mondale as a special envoy to meet with President Suharto. His mission: convince Suharto and the Indonesians to bite the bullet and stick to the IMF plan. But however they try to do it, the aim is clear: to restore confidence in the rupiah--in which case the demand for it will rise relative to the supply, and, all else equal, the Indonesian economy could start growing once more.
A RealAudio version of this segment is available.
