Challenge of sustaining recovery

By Anoop Singh

JAKARTA (JP): With a much more stable macroeconomic environment, the successful completion of historic elections, strong international support for Indonesia's economic reforms and an ongoing recovery, market confidence should be on the rise.

However, this is not yet the case, and the question on everyone's mind is how Indonesia can best sustain the recovery. In addressing this issue, let me touch on three main topics

* First, it is useful to remind ourselves how far Indonesia has come since the crisis in 1998.

* Second, the economic factors that are weighing down market sentiment, especially the burden of government debt.

* Third, the approach of the economic program in addressing the problem of government debt and assuring sustained growth over the medium term.

It is hardly necessary to recall the crisis that prevailed in Indonesia just two years ago. By mid-1998, the exchange rate had collapsed, reaching a low of more than Rp 15,000 to the U.S. dollar.

Output was contracting sharply and, with rising food insecurity, the country was on the verge of hyperinflation. The banking system had virtually ceased to function and the corporate sector was weighed down by the recession, inflation and debt. In short, Indonesia was in a vicious downward spiral.

Much of this now seems long ago and far away. Output has been growing steadily for about a year. Inflation has been kept low. The rupiah has been much more stable, fluctuating in the range of Rp 8,000 and Rp 9,000, which is lower and more volatile than justified by the fundamentals, but certainly much better than before.

Finally, the poverty rate -- by most accounts -- has fallen back sharply to well below its level at the peak of the crisis.

What explains these results? What stands out is the development and implementation of a sound macroeconomic framework, especially a radical reorientation of monetary policy focused on the targeting of base money, and a fiscal policy that helped expand the social safety net. This was supported by successive measures to restore confidence in the banking system and rebuild key economic institutions.

Let me now turn next to discuss the challenges that lie ahead. The most immediate of these challenges is to restore market confidence in Indonesia's economic prospects -- this is crucial to revive the investment and capital flows necessary to deliver sustained growth.

Among the economic factors weighing down market sentiment is the slow progress Indonesia has made in asset recovery or restructuring, relative to the large size of the problem. This has led to concerns about fiscal sustainability.

Fiscal sustainability means the government is in a position to repay its debts, both now and in the future, in an orderly way -- without resorting to extraordinary measures.

A simple measure of sustainability is a declining trend in the debt-to-GDP ratio. Such an outcome generally requires the rate of economic growth to exceed the real interest rate. Without this condition, the burden to run a fiscal surplus increases.

Markets worry about fiscal sustainability in Indonesia because the government's debt amounts to around 90 percent of its annual output, which is one of the heaviest debt burdens in the region.

Thus, it is very important for markets to be reassured about the government's ability to meet its debt servicing burden in an orderly way. As long as investors doubt this ability, real interest rates will have to remain high.

There are many international examples of countries where concerns about fiscal sustainability kept interest rates well above the inflation rate, contributing to low growth. Therefore, it is imperative to prevent Indonesia from experiencing the same fate.

I will now briefly discuss the elements in the government's approach to support this objective.

The importance of fiscal sustainability -- of bringing down the debt burden in an orderly way -- was well recognized by the legislature last year, when it enunciated the State Policy Guidelines.

The present economic program builds the framework to accomplish this reduction in the government's indebtedness, and seeks to do so in an orderly way.

The basic strategy relies on maintaining a favorable macroeconomic environment, making progress with fiscal consolidation and driving asset recovery.

All of these factors would have a mutually reinforcing effect on stimulating new productivity -- enhancing investments and capital flows, reducing real interest rates and raising growth, thereby satisfying the conditions for reducing the debt ratio.

Setting in train -- and entrenching -- such a virtuous cycle is the fundamental aim of the economic program. If fully achieved, our projections point to the government debt ratio falling to about 67 percent by 2004.

Let me now go on to discuss in more detail the principal avenues available to the government to bring down the debt ratio in the next few years. Many of these avenues will tend to -- indeed are necessary to -- raise efficiency and factor productivity at the same time.

First, adjustments in the government budget.

During the crisis, Indonesia's budget balance moved into deficit because of the need to support domestic demand, cushion the output decline and expand support for the poor. Now that recovery is underway, it is appropriate that the process of scaling back the fiscal deficit should begin.

This will not be an easy process. Many parts of the expenditure budget have already been squeezed, and there is still substantial need for infrastructure and social safety net support.

That is why a strong political consensus will be needed on how best to pursue fiscal consolidation and to make the necessary choices:

* There is also considerable scope to strengthen the revenue base of the government. Commendably, the government has already expressed its intention to rationalize the large number of exemptions and tax holidays which have reduced the revenue base, in many cases, without commensurate benefits.

* Within expenditures, civil service reform is an avenue for budgetary savings -- and also greater efficiency. Because of successive and large wage increases over the past two years, the government's wage bill -- as a ratio to GDP -- has risen to above 5 percent of GDP, which is above that of many similarly placed countries.

* During the crisis, government spending on subsidies increased. However, much of the budgetary subsidies are not of a targeted nature, and there is no assurance that the benefits accrue to the poor. Such untargeted subsidies presently amount to as much as 3 percent of GDP, almost equal to the entire international support for the budget, and can be reduced without affecting the poor.

Second, implement fiscal decentralization without adding to the budget deficit.

The government is currently preparing to implement fiscal decentralization in 2001. The international experience clearly points to the risk that the general government deficit could rise following decentralization. If this were to happen, it would make it all the more difficult to bring about a reduction in Indonesia's burden of government indebtedness.

For this reason, the government is taking a number of actions to preserve fiscal neutrality during the decentralization process.

Perhaps the most important enabling condition is to ensure that expenditure functions are transferred to local authorities to match the revenues that they are receiving.

If this is not done, an additional burden would be placed on the government budget, at a time when it can least afford it. In short, finance should follow function, and not the other way around.

The government is also considering other measures that would contain the macroeconomic risks of fiscal decentralization and ensure that the overall debt reduction strategy remains on track.

International experience strongly suggests that borrowing by subnational governments should be subject to strict limits, particularly in the early stages of decentralization.

Also, the overall budget framework of the central government needs to retain some flexibility in case some of the risks do materialize. This is commonly done, in many countries, by creating a margin within expenditures that is maintained as a contingency against unexpected risks.

Third, pursue recovery from publicly held bank and nonbank assets.

Asset recovery is of the highest priority in the economic program, and not only because of its considerable potential to help bring down the government's debt. Of equal importance is the role that asset recovery can play in sustaining the recovery.

As is well known, the Indonesian Bank Restructuring Agency (IBRA) controls a very large amount of assets -- whose book value has been measured at close to one-half of annual GDP. These assets need to be put back in the private sector where they would be more efficiently deployed.

The longer the assets remain in the hands of the government, and despite the best intentions of IBRA, the more likely the assets will deteriorate.

The same with asset sale prices; delaying asset sales until their prices firm usually produces the opposite result. These are the clear lessons from every country that has been faced with this task, and they are also the emerging lessons from Indonesia's own experience.

In contrast, accelerating asset recovery would jump start the revival of foreign investment in Indonesia and raise factor productivity, both of which are crucial for sustaining growth, while also helping strengthen the rupiah closer to its fundamentals.

Overall, over the next few years, bank asset recovery and the proceeds of nonbank privatization could be as important as the adjustment in the budget deficit in their contribution to reducing the debt ratio.

All the institutions concerned need to play their part -- especially IBRA and the Jakarta Initiative Task Force (JITF) -- as well as the government as the owner of the state-owned enterprises.

Fourth, safeguard public resources from being used for additional bank recapitalization.

The principal reason why Indonesia's government debt has risen so much during the crisis is because of the need to recapitalize the banking system. Indeed, there were previous episodes of bank recapitalization at public expense in the 1990s.

For this reason, it is critical to ensure that, once the present recapitalization is completed, the government does not need to lead another bank recapitalization in the future. Ensuring this entails the following:

* Enhanced supervision of the banking system is paramount to protect against the abuses of the past repeating themselves.

* Transformation of Indonesia's banks into genuine intermediaries of the financial savings of the community. For far too long, the banks have been the vehicles of directed lending, of one sort or another, and this was the true heart of Indonesia's financial crisis. Nothing short of a culture change is at stake.

* Privatization of the large state share in the banking system. Such a process, as observed elsewhere in Asia, will not only bring in much needed new capital into the banking system and strengthen its ability to extend new credits, but also build up the financial and competitive strength of the banking system.

In conclusion, I have stressed that a coordinated strategy to reduce the government debt is an essential part of the process of restoring market confidence and sustaining the emerging recovery. Of course, this is not the only part of the process, but it may well lie at the heart of it.

The international community is fully committed to helping Indonesia meet the challenges that are involved in this task. Just recently, the International Monetary Fund's executive board completed the second review of Indonesia's fund-supported economic program, and I speak on the eve of an important meeting of the Consultative Group for Indonesia.

Our role -- that is to say, the role of the international community -- is to give technical assistance, policy advice and financial support for the implementation of the economic program.

The program itself, as repeatedly emphasized by Coordinating Minister (for the Economy) Ramli, is very much that of the government. We are there to support it.

The writer is the IMF deputy director for Asia Pacific. The article is based on his talk at the University of Indonesia's 50th Anniversary Conference.