International Finance and Domestic Financial Market Development: The Case of Indonesia

Abstract

The order of financial market reform in Indonesia, which largely preceded real sector liberalization, was unusual as the external capital account was opened prior to domestic financial market reform. It is posited that changes in financial market policies in Indonesia were strongly influenced by changing circumstances in Indonesia’s access to external finance and to changing conditions in international financial markets. For example, the oil boom and petro-dollar recycling phenomenon reduced Indonesia’s fiscal and financial constraints and, consequently, domestic financial markets became highly regulated and credit and savings flows subject to state controls. The end of the oil bonanza meant tighter fiscal constraints and necessitated tax and financial reforms aimed at boosting savings and increasing the efficiency of domestic financial markets. The success of Indonesia’s financial reforms, though not without problems, provides another case study on the crucial role financial liberalization can play in overall economic development.