ASIAN AFFAIRS ON INDONESIA

Hadi Soesastro - Executive Director - CSIS

THE INDONESIAN ECONOMY: WHTA WENT WRONG

Until the onset of the crisis in the middle of 1997, the Indonesian economy has grown by an average of 7 percent per annum for about three decades. This sustained growth has transformed the economy from an agricultural economy to a newly industrializing economy. The contribution of the agricultural sector to the economy's GDP (gross domestic product) has been reduced significantly from close to 60 percent in the late 1960s to less than 20 percent by mid-1990s. The role of the manufacturing sector increased during that period from 8 percent to about 25 percent. Yet, one of the anomalies in Indonesia's development pattern is the continued importance of the agricultural sector in labor absorption. In other words, the agricultural sector has been forced to continue to absorb large numbers of labor that fail to find other job opportunities. In the late 1960s, about 80 percent of the labor force was in agriculture. By mid-1990s about half of the labor force still drew their livelihood from agriculture (including animal husbandry, fishery and forestry).

There are a number of reasons for this anomaly. Most important of all has been the dualistic nature of the economy and society. The large agricultural sector has remained largely traditional in its production and organization. Although the government has allocated large resources to the development of agriculture and the rural areas, the activities that are undertaken by the people, the so-called people's economy, continue to characterized by their low labor productivity. Yields (of rice and other crops) per hectare have increased, but these have been achieved largely by intensification, primarily through the use of subsidized fertilizers. The quality of labor in the traditional sector, in terms of education, skill and mastery of technology, has hardly improved. In terms of economic organization, the government has encouraged the establishment of cooperatives, but most of them ended up being an extension of the government's bureaucracy.

The rapid development of the manufacturing sector, which became the core activity of the modern sector, has not produced an equally rapid growth in manufacturing employment. This has been caused by the pattern of investment that initially produced inefficient import-substitution industries that tended to be capital intensive. It was only in the past ten years that manufacturing activities began to be redirected towards export-orientation. This also led to the development of more labor intensive manufacturing. With the liberalization and deregulation of the economy since mid-1980s, the pattern of industrialization has been brought closer to the country's comparative advantage. Yet, the country's advantage in low labor cost appears to have eroded rapidly. The introduction of such social policies as minimum wages may have its share of the blame. But in many instances, this potential advantage has been wiped off by the systemic corruption that is so rampant in the economy and society. In addition, there is increased competition from new, lower cost producers in China, India, and Vietnam.

In view of this dualistic nature of the economy, official statistics have shown that income distribution has been less unequal than in other large developing economies and that it has not significantly worsened. The objective of policy has been to focus more on the reduction of absolute poverty. Official statistics have also shown that during the past 30 years, the percentage of population living under the poverty line has been drastically reduced from close to 70 percent to less than 20 percent. However, there has been much debate about the validity of these statistics. More studies and research are needed to be able to draw more firm conclusions on. The general public perception is that overall the livelihood of the people has improved. Yet, the feeling is that there is an over-concentration of wealth and economic activity amongst a privileged group in the society, namely the cronies and the conglomerates, the politically well-connected and ethnic Chinese businesses.

Regional distribution is also an issue. Some regions, such as these small islands in the Eastern parts of Indonesia, are poor because they are poor in natural resources and are sparsely populated. They suffer from the problem of small, isolated island economies. The central government has been subsidizing these economies by taxing on the rich regions. But the rich regions have been unhappy about this. They are not against subsidization of the poorer regions, but they feel that the central government has taken too much for itself. As can be expected, per capita gross regional domestic product in 1997 was highest in Jakarta (Rp 9,800,000), which was about 9 times that in East Nusa Tenggara (Rp 1,100,000).

Indonesia has had these problems for many years. The secessionist movements in the 1950s were related to regional distribution issues. Resentments against the economic role of the ethnic Chinese have been there since the colonial period. In a sense, the Soeharto government has managed to live and deal with these problems by suppressing them. These became more difficult in the later years, primarily because the regime has become more centralized and heavy-handed, and because of the concentration of power with the President. The crisis of 1997 greatly exposed the structural weaknesses of the country, economically and politically. In the 1970s and 1980s Indonesia had also faced an economic crisis caused by an external shock, but each time the economy was able to come out stronger because the crisis forced the government to undertake the necessary measures and reforms. This time around the government failed to do so, because having been in power for so long the Soeharto regime was already decaying and was unable to understand the new challenges that it faces. Almost within one year many of the achievements made during the past three decades have been wiped out.

The Crisis and Beyond

If a crisis is a blessing in disguise, it should be a cause for renewal. Even though Soeharto has left the scene, the era of "reformasi" or reform has yet to come. The economy under the Habibie transition government is still in disarray. The task of this government is to turn the economy around and to revive economic activities. Yet, an equally important, if not more urgent, task is to assure that the political transition to a new government will be smooth. The time table for the political transition has now been set.

The picture today is that of very confused economic policy making and implementation. On the one hand, the government has pledged to continue with the economic stabilization program agreed upon by the previous government with the International Monetary Fund (IMF). In addition to adopting a tight monetary policy and a restraint fiscal policy, which have nonetheless resulted in a huge budget deficit, the IMF policy prescriptions include a continuation of the structural reforms in various fields, and further deregulation and liberalization of the economy as a whole. On the other hand, the government has introduced new policies with a strong political agenda that tend to interfere with or run counter to the overall economic stabilization and recovery program.

On top of this, there are increased pressures from within the society for the government to reassess the country's development strategy. A growing number of people believe that economic liberalization has been the main cause for the crisis that has befallen Indonesia. To them, Indonesia's development strategy should be reoriented in the direction of greater exploitation of Indonesia's own strengths and become less dependent on external resources. Others have pointed to Soeharto's crony capitalism as being the main cause of the crisis. The fall of Soeharto and the crisis have begun to dismantle the business activities of Soeharto's cronies. However, this has also led to a systematic attack on the so-called "konglomerasi" or the dominance of big business in economy. The "populist' policy of economic empowerment of the people under the banner of the people's economy that has been sponsored by the Habibie government is being presented as an alternative to Soeharto's economic policy of favoring the development of the conglomerates. While the policy of siding with the small, the weak and the cooperatives has great appeal, there is an equally strong skepticism about its successful implementation. What is a greater cause for concern, however, is the diversion of government's attention and efforts away from the critical task of economic stabilization and recovery to the more politically attractive measures of empowering the cooperatives, the small and the weak. In the mean time, not much progress has been achieved in implementing the more urgent social safety net programs.

The cost of the social safety net is estimated to be quite significant. The government, with the help of the IMF, has been able to secure an inflow of public funds that could amount to about US$ 14 billion for the current fiscal year ending in March 1999. In addition, some donor countries have agreed to reschedule Indonesia's sovereign debt of about US$ 4 billion. These public resources have helped to keep the economy afloat. However, the revival of economic activities has not come about. Restructuring and recapitalization of the economy have been very slow and far from significant. The process of restructuring is difficult and painful, but this becomes all the more impossible under uncertain and deteriorating political conditions. There is the concern that the country cannot rely on another large inflow of public resources to help finance the 1999/2000 budget.

The revival of the Indonesian economy depends on efforts and measures taken on many fronts simultaneously and in a coordinated, coherent fashion. On the economic front the agenda consists of two big tasks, namely macroeconomic stabilization and structural reforms. Progress in each of these tasks mutually influences each other. On the social front, social safety net programs are the core of the efforts to lessen, or if possible, eliminate the hardship faced by groups in the society that have been affected most by the prolonged crisis. On the political front, it is obvious that without a smooth and fair elections next year the situation is not likely to improve.

Macroeconomic stabilization involving the adoption of a tight monetary policy, as prescribed by the International Monetary Fund (IMF), is being widely criticized as a wrong medicine for Indonesia and other crisis-affected countries. The arguments have been made repeatedly, namely that the crisis in Indonesia and other Asian countries did not originate with an over-expansion of the public sector but due to over-borrowing by the private sector, especially from external sources. When the currency depreciates and much of the external borrowing was unhedged the private sector found itself in an insolvent situation. Hence, the proper rescue operation should be an injection of capital and not through a drastic drying up of financial resources by adopting a tight monetary policy. Critics have pointed to the fact that after more than one year the policy has not produced the expected results. Meanwhile, it is difficult to expect that the real sector of the economy would be able to revive its activities under the prevailing high nominal interest rates.

The last quarter of 1998 saw some improvements in some macroeconomic indicators. Inflation has been checked although for the entire 1998 it reached close to 80 percent. For about four months until the middle of January 1999 the exchange rate has been hovering around Rp 7,500 to Rp 8,000 per dollar. However, many have cautioned that these improvements are not yet supported by an improvement of the country's economic fundamentals. In fact, these improvements can only be sustained when real progress is achieved in regard to structural reforms. Recapitalization of the economy will only come about as a result of these structural reforms. The agenda for structural reforms includes, most importantly, the restructuring of the banking sector, the resolution of external private debt, and privatization of state-owned enterprises (SOEs). Trade financing and foreign direct investments will also play an important role in economic recovery.

Until today, efforts to resolve the banking problem have been slow and frustrating. Partly, this is because of the magnitude of the problem. The problem with the Indonesian banking sector predates the crisis. The banking sector expanded too rapidly following liberalization in the late 1980s without adequate capacity of the Central Bank to supervise. However, the banking crisis began when corporations began to default as a result of the crisis. The big blow that led to a total loss of confidence in the banks by the public followed the liquidation of 16 banks in November 1997. No deposit guarantee scheme was in place at that time, and the criteria for the closure were not made clear by the government. This has led to panic withdrawals of funds from national private banks. Bank runs took place following unfounded rumors about bank closures so that even the largest and relatively healthy banks were severely affected. Being a lender of last resort, the Central Bank was faced with the dilemma of letting the affected banks go under with the risk of destroying the entire banking system or providing them with liquidity support. A full deposit guarantee was introduced at the end of January 1998, but this had no immediate effect on restoring confidence in the banking system.

In January 1998 the Indonesian Banking Restructuring Agency (IBRA) was established to supervise and manage the restructuring of banks in poor financial condition and to be the management agency for assets that it acquires in the restructuring process. The cost of recapitalization is estimated to amount to over Rp 300 trillion, or about 50 percent of GDP. The financing of this recapitalization is a highly politically sensitive issue. The government plans to issue bonds to finance 80 percent of the recapitalization needs and the interest will be partly paid through the budget. The parliament has objected to this plan. It is important that measures to restructure the banks are understood as a necessity to save the banking system and not seen as rescuing the owners of the banks.

Similarly, the problem of external private sector debt remains unresolved. The information collected by the Central Bank suggests that by the end of March 1998 the private sector's external debt amounted to about US$ 72.5 billion of which about half was to be repaid within one year. Of total private sector's external debt only about US$ 8 billion (11 percent) were contracted by private banks. The government's policy is not to bail out any private company. Instead it encouraged private borrowers and lenders consult with each other in good faith in resolving the problem.

Since December 1997 most Indonesian companies have stopped making debt service payments on their external debt. In June 1998 a framework for resolving the problem was agreed upon. Yet, no negotiations between borrowers and lenders took place following this agreement. In August the government established the Indonesian Debt Restructuring Agency (INDRA). Its operation involves a conversion of the foreign exchange loans of participating domestic debtors into rupiah denomination and their repayment switched to INDRA, which will make the repayments in foreign exchange to international creditors. Thus far, INDRA does not have its takers.

These developments suggest that recovery of the economy is likely to be slower rather than faster than expected. Much of the problems with the structural reforms relate to either the lack of political will or absence of a clear policy. In addition, in all of them the main problem is that of weak institutional and legal capacity. This, however, is not sufficiently recognized by the policy makers.

A Concluding Note

Perhaps it is after all true to suggest, as Paul Krugman did before, that growth of the Indonesian economy during the past decade or so has been sustained mainly by the huge inflows of capital. It was this capital inflow too that creates vulnerabilities in the economy that led to the crisis. Overcoming the crisis, however, requires a large injection of financial resources from the outside. Public resources through the IMF and donor countries have kept Indonesia afloat. But the revival of the Indonesian economy requires huge inflows of private capital. This is ironical. In the short to medium term there may be no alternative to this. Yet, for the longer term the task is to develop and exploit Indonesia's own strength and resources.

Note: Jusuf Wanandi contributed to this article (see interview in this issue).