Financial Instability in Indonesia: Theories and Practices

This thesis investigates the instability of a financial system by taking a specific country’s example with the Indonesian financial system as a case study. To achieve its objectives, this research study aims to answer the following questions: (1) Are there any factors that contribute to financial instability? (2) How is the state of the financial system? (3) Are the policies available effective at dealing with financial instability, in particular external instability? To answer these questions, this study discusses the Financial Instability Hypothesis, employs different time series techniques, explores the relationships between relevant variables and investigates specific events within the observation period. First, this thesis examines the arguments of McKinnon (1973) and Shaw (1973) and applies them to the implementation of Indonesian financial reforms. By modifying IMF’s financial liberalisation index and using it as one of the control variables, this thesis finds that financial liberalisation has a positive association with the volatility of the exchange rate. Second, this thesis develops the measurement of financial instability and investigates the potential for it to become an instrument for the detection of the country’s fragility condition. In developing these instruments, this study takes two different approaches into consideration, namely the ‘static’ and the ‘dynamic’ approaches. The former argues that the cause of financial instability is an exogenous process or a random shock. The construction of the instrument has the main purposes of predicting the occurrence of a financial crisis and measuring the instability of a financial system. Whereas, the latter assumes that financial instability is an endogenous process. In constructing the instrument, it has the objective of detecting the condition of a financial system. This study applies the financial instability measurements in Indonesian’s case and compares their performances with respect to crisis prediction. Third, this study investigates policies to handle the capital flows. It explores the implementation of policies to handle and manage the capital flows. Based on the empirical analysis, this study finds that the capital management policies fulfill its objectives in managing capital flows. Besides, this thesis examines the implementation of the compensation thesis and finds that this mechanism applies to Indonesia.