Mon, 10 Feb 2003

Does Indonesia still need the IMF's assistance?

Kahlil Rowter, Lecturer, School of Economics, Universitas Indonesia, Jakarta

The government is mulling whether or not to extend its arrangement with the International Monetary Fund. What is at stake here is not a quantifiable threat to the state budget or the balance of payments but policy making credibility.

The first question to ask is: Are we ready? We should remember why Indonesia engaged the assistance of the IMF in the first place. Its primary role is to rescue nations undergoing a balance of payments crisis, which is exactly what Indonesia faced in late 1997.

In the fourth quarter of 1997 and the first quarter of 1998 over US$11.6 billion in private capital escaped. Reserves dropped from seven months worth of non-oil and gas imports to 4.6 months. And there were indications that the bleeding would continue.

Therefore, as a member of the IMF we sought its aid. The crisis which started with a sudden loss in confidence soon spread into banking and debt crises (technically from a liquidity to a solvency problem). The prescription naturally involved tackling immediate as well as more structural issues. Hence, the series of letters of intent (LOI) which addressed a whole range of issues outside the immediate liquidity crisis.

Now, the banking system has stabilized, there is ample foreign exchange reserves, the rupiah has stabilized and interest rates are falling, and there is modest economic growth. There are certainly risks, but with low probability of an immediate economic threat of the magnitudes seen in 1997 to 1998.

What about the financial implications of not extending our arrangement with the IMF? Currently we owe the IMF about $13.37 billion. The IMF has committed close to $5 billion in the latest arrangement due to end in December 2003. Until December 2002 Indonesia had drawn down about $3.1 billion, which leaves about $1.9 billion which the government plans to draw down this year.

It is worth noting that the entire IMF loan is aimed at providing a cushion in the balance of payments in the event of another crisis. Therefore it cannot be used in the same way as a World Bank loan or a loan from the Asia Development Bank to finance government expenditure.

The payment schedule is designed to minimize pressure on the government budget as well as the balance of payments. The highest amount has in fact been paid out in 2002. The amount in the rest of the period until 2010 never exceeds $1.8 billion.

A rough calculation of the cost of the IMF program goes as follows: The total to be paid until 2010 amounts to $14.27 billion, including the amounts paid in 2001 and 2002; the total cost of the package over its life, therefore, is close to $1 billion (the difference between the outstanding loan and the total to be paid out). Naturally this is very cheap compared to commercial loans.

What about the burden on the government budget? It is the government, after all, that borrows from the IMF. From the recent government budgets we see that about $8 billion has been set aside for paying external debt interest and principal. Therefore the IMF payment burden averaging $1.2 billion for the next eight years would not unduly burden the government's capacity to pay.

If the balance of payments and the government budget will not directly be jeopardized, are there any other costs that the Indonesian economy must incur with the termination of the IMF? Yes. And it has to do with the country's reputation.

Like it or not the LOIs have been perhaps the only economic program, albeit a short term one, that Indonesia has tried its hardest to follow. This is because the LOIs have an effective system of reward and punishment. Follow the prescription and you will be rewarded with additional disbursement, and your reputation is enhanced. Do otherwise and not only is money withheld but your reputation suffers.

And this makes it all the more difficult to formulate and implement your agenda. Even so, Indonesia has reneged many times and has suffered the consequences. In the short term mainly in the form of weaker rupiah which translates to higher inflation and interest rates. In the longer run, the cumulative effect of more than a single non-compliance increases the punishment exponentially. In practical terms the existence of the IMF program ensures that there is a "guarantor" that keeps constant vigil.

What would be the impact when this "guarantor" is no longer in place? One immediate result is that Indonesia will not get another Paris Club rescheduling due to its conditionality on having an IMF arrangement in place.

But beyond that is the loss of the one economic program that is the most verifiable and one that most (if not all) government, private and political components know is almost non-negotiable. What substitute, if any, can Indonesia put in its place that would ensure the compliance of government officials and elicit foreign trust?

In order to signal its seriousness the government should institute an economic plan that is not only sober and at the same time comprehensive, but to be convincing it must be quantifiable and verifiable -- and most importantly it must contain punishment mechanisms that are painful to create enough negative incentive for not reneging.

One such instrument is to maintain the inflation-indexed bonds that the government has issued to the Bank of Indonesia. This signals its firmness toward keeping inflation in check, or else it faces the consequence of higher financing cost.

Another would be to issue foreign currency denominated bonds that increase the government debt servicing cost should the rupiah depreciate.

Having strict policy deadlines would alleviate indecisiveness. There are a host of other instruments that can be employed to increase the pain of policy failure. But back to the question: Can Indonesia come up with one in time? If not we might be better off keeping the IMF a bit longer although the political cost might be high.