By DAVID WESSEL, DARREN MCDERMOTT and GREG IP Staff Reporters of THE WALL STREET JOURNAL

Six months ago, Indonesia wasn't an economy in trouble. The International Monetary Fund lauded it in June for "prudent macroeconomic policies, high investment and savings rates, and reforms to liberalize markets." Since then, Indonesia's rupiah has fallen by more than 50% against the dollar, pounding banks and businesses that had borrowed billions of U.S. dollars and are hard pressed to repay at current exchange rates. A recession is all but inevitable. Who did it? Indonesia is one of the mysteries of Asia's financial catastrophe. The most recent rupiah weakness is easy to explain: rumors about the health of Indonesia's long-ruling 76-year-old president, Suharto. But what started the stampede back in July, after the rupiah had initially only been jostled a bit by nearby Thailand's currency turbulence? What propelled the herds to flee the rupiah in August, forcing Bank Indonesia to let the currency plummet? And why did the rupiah keep falling thereafter?

Some Indonesian officials were quick to blame currency speculators, the nemesis of emerging-market governments worldwide. "If indeed they cause Urged to disorder in the national economy, Renegotiate Loans it can be categorized as a subversive criminal action," the justice minister warned in August. In Indonesia, subversion is punishable by death. But at least in this case, megaspeculators like George Soros aren't to blame. Although some small-time currency traders did profit from the rupiah's decline, interviews with hedge-fund managers and other players in global markets from London to Singapore, as well as with central bankers and IMF officials, suggest that big-time speculators and huge hedge funds weren't a major factor in the rupiah tumble. Managers at Mr. Soros's Quantum Fund and Julian Robertson Jr.'s Tiger Management Corp., in fact, say they not only didn't bet on a rupiah decline but bought rupiah in recent months, hoping for a bounce. "We all have the idea that it was the nasty hedge funds that were going around shorting currencies, but that's just not so," says Bill Sutton, who keeps tabs on Asian currency markets from Merrill Lynch & Co.'s high-rise trading room in Singapore. Instead of shorting the rupiah -- selling borrowed currency in the hope of repaying it cheaply after it falls -- Mr. Sutton says, "the vast majority of hedge funds, real-money funds" -- meaning mutual and pension funds -- "and other [institutional] investors were fully invested in the rupiah."

Dollar Debt

So if the sometimes-feared, sometimes-envied big hedge funds weren't the primary culprits, whose actions did knock down the rupiah? Try P. Manohar, the treasurer of PT Polysindo Eka Perkasa, a big Indonesian polyester producer that had borrowed more than $800 million in dollars to avoid punishingly high Indonesian interest rates. At the first whiff of trouble in July, Polysindo hedged $200 million of its dollar debt. For a fee, it bought the right to sell rupiah for dollars in the future at a set price. It was a maneuver that, when repeated by scores of other Indonesian borrowers, pushed down the rupiah's value. Or try Pedro Marcal, not a currency speculator but a mutual-fund manager at Nicholas-Applegate Emerging Countries Fund. Uneasy about Indonesian developments in late July, he sold shares in an Indonesian auto maker. In doing so, he exchanged rupiah proceeds for dollars, contributing in his own small way to the decline of the rupiah, along with many other foreign investors who did the same. Fear Prevails In other words, if markets reflect an endless tug of war between greed and fear, in this case the dynamic was largely fear -- a self-fulfilling fear among Indonesian borrowers who had bet on currency stability, and a fear among global investors in Indonesian securities that the once-promising companies were about to stumble. Although Indonesia is a huge country (200 million people), the market for its currency is small. Precrisis rupiah trading was less than $5 billion a day, a sliver of the more than $1 trillion daily trade in currencies. Ever since a traumatic 31% devaluation in 1986, caused by falling oil prices, Indonesia had successfully linked the rupiah to the dollar, allowing it to fluctuate day-to-day within a narrow band. To compensate for differing inflation rates and to keep exports competitive, the central bank moved down the band's midpoint at a gradual and predictable 4% to 5% annual pace. Pushed by technocrats and pulled by business interests and Suharto cronies, Indonesia over the past 20 years has moved away from a government-controlled financial system toward a more market-based one. The number of privately owned banks has soared. The once-comatose Jakarta Stock Exchange has awakened since the government scrapped rules that kept foreigners out. Since 1967, Indonesia has let money flow across its borders with few restraints.

The combination was powerful: a relatively open financial market, a growing eagerness by global investors to put money in Asia and a cadre of expanding Indonesian companies trying to avoid high Indonesian interest rates, which the central bank had pushed up to keep the economy from overheating. Compared with Thailand and Malaysia, Indonesia's economy, though hardly problem-free, seemed reasonably sound. The result was a flood of dollars into the country -- much more than banks and companies could invest wisely, it turned out. "Everyone assumed the money would always be available and took advantage of it to grow," says Polysindo's Mr. Manohar. Counting on continued growth and a predictable currency, Indonesian nonfinancial companies more than doubled their foreign borrowing from the end of 1995 to mid-1997, according to Standard & Poor's. As of Sept. 30, according to President Suharto's new special adviser on debt, Radius Prawiro, Indonesia's total foreign debt was $133.3 billion, of which $65.6 billion was owed by private companies. Says central-bank chief Soedradjad Djiwandono: "We started building the foundations of a house, but suddenly we had to host a party." * * * Indonesian borrowers faced a simple choice. They could borrow rupiah at 18% or 20% and not worry about the exchange rate. Or they could borrow dollars at 9% or 10% a year and then convert the proceeds to rupiah. A year later, they figured, it would take 4% or 5% more rupiah to buy the dollars needed to repay the loan, but the cost still was less. Some Indonesians borrowed dollars and invested in rupiah securities and bank accounts just to profit from the interest-rate differential. "Borrowing U.S. dollars was part and parcel of life in Indonesia. It was like going to McDonald's," says Kenny Tjan, who runs Nomura Asset Management Co.'s Jakarta Growth Fund from Singapore. The central bank, Bank Indonesia, had trouble keeping track of all the short-term foreign borrowing Indonesians were doing, but it knew this borrowing was heavy. "The currency was on a steady course," Mr. Soedradjad notes. "And we had all these banks from all over the world landing here and handing out the money." It is now clear that Indonesian companies made a huge bet that went bad: Few executives took seriously the possibility that Bank Indonesia would let the rupiah fall sharply. Even fewer were willing to pay the cost of hedging, insurance that banks and investment houses sell to protect against currency collapse. In late July and early August, Goldman, Sachs & Co. surveyed 34 Indonesian chief financial officers. Two-thirds had more than 40% of their debt in foreign currencies; of those, half were completely unhedged, and most of the rest had well under half of their debt hedged. That proved a costly mistake. To repay a $100 million loan in early July took 243.1 billion rupiah; to repay it Monday took 500 billion rupiah.

The world began to change for Indonesia on July 2, when the Thai government ran out of reserves to support the baht and allowed it to fall freely. At first, the rupiah hardly wavered. Nine days later, the Philippines let its peso fall freely. That afternoon, Bank Indonesia widened the rupiah's trading band to 12% from 8%, permitting the currency -- then worth around 2,450 to the dollar -- to move as much as 300 rupiah against the dollar every day. The central bank bought or sold rupiah when the currency moved outside the band it set. "We were hoping people would realize we were working to a free float," Mr. Soedradjad says. "But the turbulence came too soon. We were overtaken by the market." Slouching in an enormous dark-green leather armchair for an interview, the central banker recalls that speculators, both domestic and foreign, have long made money buying the rupiah when it dipped on rumors, often about Mr. Suharto, and selling on the rebound. So when "some smart people started selling the rupiah" in July, the first reaction of domestic players "who were not very smart" was to buy. But within a week, local investors -- "going by a herd instinct more than usual" -- realized there would be no rebound this time, he says. In one way or another, they began to sell rupiah. Polysindo offers a case study. In July the company was in the midst of raising $250 million to finance stage one of a big expansion. It made a public offering of 10-year notes at 9.375% interest. Of course, a prolonged rupiah fall would make that burden of dollar debt heavier, as it would for any firm that earned its revenue primarily in rupiah. But Polysindo suggested in filings with the U.S. Securities and Exchange Commission that the turmoil was temporary and "primarily due to speculative trading." Polysindo didn't link the pressure on the rupiah to another factor, also disclosed in the U.S. filing. It had arranged to sell rupiah and buy dollars at some future time. It contracted to exchange 491.4 billion rupiah for $200 million, or 2,457 rupiah to the dollar. Later it contracted to buy an added $175 million at a rate of 2,988 rupiah the dollar. (Monday, the rupiah traded about 5,000 to the dollar.) In the more liquid markets for U.S. dollars or Japanese yen, such "forward contracts" by companies rarely influence exchange rates. But in the much smaller rupiah market, dealers notice a surge of companies suddenly seeking to buy insurance against a currency drop. "The dealer counts the votes," says Richard Lyons, an economist at the University of California at Berkeley. "The votes are the flow of orders." The vote influenced the price at which dealers would buy the currency, and it was running against the rupiah. Asked about its hedging, Polysindo said in a written reply that with the rupiah beginning to show some instability, "management made a decision to take forward contracts to ensure that its assets and liabilities were matched. ... This decision was a prudent, conservative decision made in the best interests of the company's shareholders." Such insurance wasn't cheap. Another textile company, Indo-Rama Synthetics, completed a $175 million, five-year loan with five international banks in April. The timing was good and the interest rate attractive, less than one point over the benchmark Singapore Inter-Bank Offered Rate. "We've come of age," an official boasted. But in July, Indo-Rama executives began worrying about "the Thai effect." In what turned out to be a wise move, they paid between 8% and 12% of the total loan to obtain the right to get $175 million at 2,650 rupiah per dollar, regardless of the market rate. "It was the first time we had ever done something like this," an Indo-Rama executive says. "Obviously, now we wish that we'd put all our cash into dollars and just sat things out." Indo-Rama says the bank with which it did the deal doesn't want to be identified. Perhaps for good reason. An Aug. 27 notice in a newspaper owned by the Indonesian Muslim Intellectual Association -- led by a government minister and close Suharto adviser -- pictured an Indonesian businessman's face wrapped in dollar bills, like a bank robber's mask. "By joining speculation in the dollar," the notice read, "it means you are one of the terrorists against the country's economy." * * *

One Sunday afternoon in late July, Mr. Marcal walked into his office at Nicholas-Applegate Capital Management atop a San Diego skyscraper, where the firm has a 24-hour-a-day trading desk. He was thinking hard about his $6 million stake in Indonesia's big car company, PT Astra International. The Friday before, the rupiah had slumped about 2% against the dollar, undermining a key reason he had bought the stock. Mr. Marcal, who earlier in his career was an aide to supply-side economist Arthur Laffer, is team leader on the firm's $240 million Emerging Countries Fund. Its strategy: To move quickly to buy stocks that seem about to benefit from some nascent trend, and move just as quickly to sell when trends shift. Back in December 1996, he heard from analysts in Jakarta that booming car and motorcycle sales suggested Astra's 1996 profits might top forecasts.That intrigued him. And the rupiah had been predictable. That was crucial: Astra buys parts in dollars and yen, but sells cars in rupiah. In mid-December 1996, Mr. Marcal bought about $4 million of Astra shares on the Jakarta Stock Exchange. Astra did report strong profits. But by July, in a spillover from the currency crises in other Asian lands, the rupiah was under pressure and Indonesian interest rates were rising. Now, this Sunday evening, Mr. Marcal was seeing the rupiah slide further. He called the Astra analyst for Merrill Lynch in Jakarta, grilling him on his earnings estimates and particularly on how sensitive they were to the rupiah. Mr. Marcal hung up, he recalls, with his mind all but made up. By the end of that day, the rupiah was off another 4%. "With the currency going down, all of a sudden [Astra] parts were ... more expensive. And the fact that you had rates rising means it hurts the consumer. So if they lowered prices, margins would be squeezed, but if they raised them, sales would slow down. I don't care if it's lower volume or squeezed margins ... something has changed for the worse." To sell, he needed the assent of at least one other manager. So he drafted a memo, and at an investment meeting the next day, after a dozen Nicholas-Applegate managers had discussed their stocks, Mr. Marcal asked them to look at Astra. One asked, "What's the balance sheet like?" Mr. Marcal replied that a big chunk of Astra's debt was in U.S. dollars. Others brought up the lessons of prior devaluations in Malaysia and Mexico. Some noted that Nicholas-Applegate already had a 57% gain in Astra. No one advocated hanging on any longer. Actually, Astra was in better shape than many other Indonesian companies because it had hedged most of its dollar debt. It did so despite the reluctance of some foreign partners and top executives. "Even some of our directors were saying, 'Why hedge?' " says Astra's chief financial officer, Rini Soewandi. "Everyone was hearing what [Finance Minster] Mar'ie Muhammad was saying, that the rupiah wouldn't devalue." As soon as the mutual-fund meeting broke up, Mr. Marcal electronically zapped a ticket to the trading desk. He attached special instructions: Pay close attention to the rupiah exchange rate you get. "In a situation like we were in Southeast Asia, you can lose a big chunk of change on the currency execution," he explains. At 7 p.m. California time, as markets opened in Indonesia, Nicholas-Applegate head trader Rob Jafek contacted a Merrill Lynch overseas office and began to unload. In two days, the fund company dumped its entire position, accounting for about a third of Astra's volume on those days. Later, a clerk presented Mr. Marcal with the currency rate: 2,625 rupiah per dollar. "Good," Mr. Marcal said. It wasn't a minute too soon: The rupiah soon went into free fall. Since then, Astra's share price, measured in dollars, has fallen more than 80%.
Other institutional investors appear to have made similar moves. One bit of evidence comes from State Street Corp., safekeeper for about $500 billion in cross-border securities holdings. When an investor sells a stock on the Jakarta Stock Exchange, it is transferred from one custodial account to another and the transactions are electronically recorded; they also are transmitted to State Street's Boston headquarters if one of its clients is involved. Tracking these settlements, a small subset of all foreign investments in Indonesian stocks, State Street says it saw the net flow of foreign money to Indonesia surge in early July as nearby nations ran into trouble, but in August there was a net outflow. Similarly, Morningstar Inc. in Chicago says that of 13 U.S. mutual funds with Indonesian stockholdings ranging from 2.8% to 10.4% of their assets at the end of June, 11 had cut that to zero by Sept. 30. * * * For the first 10 days of August, Bank Indonesia did all it could to prop up the rupiah. It raised three-month interest rates to 28% from 11%, to draw buyers to the currency. It spent some of its remaining $20 billion of dollar reserves buying rupiah. And it told Indonesian companies not to sell rupiah. "It was the sign we'd seen before, a big swell in sentiment against the currency, then a big push back from the central bank that you knew cost them a bundle and [that] they couldn't sustain," says David Carbon, a partner at Pacific Asset Management, a small hedge fund based in Singapore. "The more they hold the lid on it, the more people say they're not going to be able to hold the lid on this much longer, so let's go short it." With rumors flying in Jakarta, he says, some speculators did profit by selling the rupiah short in mid-August in anticipation that Bank Indonesia might not be able to hold the line. On the morning of Aug. 14, 1997, the bank stunned local business executives by announcing it would no longer try to manage the rupiah's value. It happened to be the 20th birthday of Bapepam, Indonesia's equivalent of the SEC, and more than 1,000 money managers, analysts and executives were in Jakarta for a celebration. Mr. Suharto was there, flanked by soldiers. A daughter, who heads Indonesia's Capital Markets Society, spoke. So did Mr. Soedradjad, the head of Bank Indonesia, who noted that the bank had been moving toward a free-floating currency anyway by widening the daily trading band. Few were comforted by his explanation. "Everybody at the conference watched the ... terminals," says Mr. Tjan of Nomura. "The central bank had let the rupiah go, and you could see it falling like a rock." Indonesian companies that had set up small meetings with analysts and investors spent the time fielding questions about the damage a falling rupiah would do to balance sheets. Indonesian companies now stampeded to buy dollars in any form. Bank Indonesia "called us up and said, 'Sell dollars, sell dollars,' " recalls Astra's chief financial officer, Ms. Soewandi. "They thought we were still back in the old model of a state economy. How can we sell dollars if we have dollar liabilities?" The currency broke the psychologically important barrier of 3,000 to a dollar. It recovered briefly, but the plunge resumed in late September. * * *

Where were the hedge funds in all this? A few got out. Some got stuck. And at least one, Tiger, jumped in with both feet. Michael Sofaer, who manages a stable of hedge funds from Hong Kong for Sofaer Capital Inc., says that, lying awake with jet lag in London last spring, he foresaw the rupiah's plunge. In early June, he paid just over $1 million for the right to sell nearly $100 million of rupiah in November at a price far lower than the rupiah was then trading. The contract jumped in value as the rupiah dropped, and he says he sold it before it expired for "several times" what he had paid. ("Too early," he adds.) The profits offset some of the losses his clients suffered on their Indonesian stocks. But Donald Krueger, managing director of a New York hedge fund called Valenzuela Capital Partners Inc., didn't see the crisis coming and didn't flee when it hit, even though the fund was holding $1.5 million of Indonesian stock. "They really do have good people running their monetary and fiscal policy," he explains. While he generally balances his stocks with derivatives that rise in value if a country's stock market falls, that is almost impossible in Indonesia. As a proxy, he sold futures on Malaysia's stock market. That wasn't enough. "When the Thai baht devalued, I did not anticipate the amount of collateral damage that the Philippines and Indonesia would suffer. The currency and stocks collapsed so quickly, you couldn't move. Some of the stocks we had in Indonesia just evaporated," Mr. Krueger says. As markets began plunging in August, associates pressed him to bail out. "I said, 'No. Four years from now, these markets will be up four or five times and we'll be glad we established these positions.' " For a time in September, it looked as if the rupiah was settling down, but at the end of the month it resumed its plunge as borrowers scrambled to make end-of-quarter payments on dollar loans. On Friday, Oct. 10, representatives of the world's biggest hedge funds, among others, were invited to Jakarta to meet government officials in a session arranged by Lehman Brothers, which advises the government, and PT Danareksa, a state-owned securities firm. On hand were government officials and Indonesian executives. It was a confidence-building session. "The purpose was to let the Indonesians tell their story," one attendee says. "They didn't want people to say, as [Malaysian Prime Minister] Mahathir [Mohamad] was, that it was a bunch of Jews who wanted to take over the country." Around the time of the meeting, there were reports, soundly denied by the hedge funds, that there had been talk of a huge, high-interest-rate loan by those funds to the government. But at least one fund found the opportunity compelling. Tiger decided to buy, figuring the rupiah, down to around 3,800 to the dollar, was due for a rebound. Tiger says it snapped up $975 million in rupiah in early October. This wasn't a big sum for the hedge fund, but it was for the rupiah market, and it pushed up the currency -- briefly. "Our people were very bullish on the rupiah," Tiger's Mr. Robertson says. But he is the boss, and "finally I just said, 'I don't want to be long any of this crap.' " Tiger held its position about three weeks and sold most of it in $150 million chunks at the end of October, plus the final piece at the end of November. * * * Mr. Robertson's move proved timely. The rupiah is still riding a roller coaster despite Bank Indonesia's attempts to stabilize it by buying rupiah at key moments. Four of the central bank governor's top aides have been purged on President Suharto's orders, and three were questioned by police over the weekend about allegations of corruption. Suharto advisers, obviously watching big commercial banks' willingness to extend maturities of South Korean debt, are calling on borrowers to "renegotiate openly" with their creditors. Polysindo, the Indonesian textile company, is struggling despite its earlier moves to hedge against a rupiah collapse. Its reported profits have been squeezed by foreign-exchange losses. Its debt securities have been downgraded by Moody's Investors Service and, in the past couple of weeks, have been buffeted by rumors of a pending default on a small foreign loan. Polysindo, which apparently had been hoping to roll over the debt, did pay on time. "Contrary to recent market rumors, the company will continue to meet all of its debt obligations," Mr. Manohar says. As for Pedro Marcal at Nicholas-Applegate, he is glad he sold Astra stock when he did. According to Lipper Analytical Services, the average emerging-markets mutual fund is down 6.25% this year, but Mr. Marcal's is up more than 5%. --Laura Jereski in New York, Michael R. Sesit in London and Henny Sender and Jay Solomon in Jakarta contributed to this article.

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