IMF is wrong in Indonesia, again

IMF is wrong in Indonesia, again

By Jonathan Pincus

LONDON (JP): The International Monetary Fund presents its
position in Indonesia as a clear-cut choice between right and
wrong. Indonesia's young democracy, they would have us believe,
has indulged in the deadly sins of corruption, profligacy and
price inflation. But redemption is still within reach if
Indonesia will accept the warm embrace of central bank
independence, tight money and fiscal rectitude.

This sort of economic moralizing plays well in the world's
financial capitals and in the financial media. But within
Indonesia things are less clear-cut. Certainly corruption is rife
in Indonesia, and any long-term solution to the country's
economic woes must begin with a strengthened legal system and
improved public sector and corporate governance.

But the problem should be viewed in its proper context. Thirty
years of military rule under former President Soeharto left a
ruinous legacy of corruption that will not be reversed overnight.

Although shaken by its own scandals, the Abdurrahman Wahid
government has taken some tentative steps to reinforce anti-
corruption laws and to bring some of the country's most notorious
offenders to justice. These include the infamous Soeharto cronies
Mohammad "Bob" Hassan, Prajogo Pangestu and former minister of
energy and mines Ginandjar Kartasmita.

But the list is long, and close relationships between the
military, legislators, big business groups, and Soeharto's
bureaucratic elite stand in the way of a swift and clean break
with the past.

These moves by the government are all the more reason for the
international community to support reformers in the government
such as Justice Minister Baharuddin Lopa and Coordinating
Ministry of the Economy Rizal Ramli.

Instead, the IMF has held up the latest tranche of its three-
year, US$5 billion assistance package because of the government's
attempt to remove Bank Indonesia governor Sjahril Sabirin and
other central bank officials implicated in corruption scandals.

Sjahril, a Soeharto appointee, has been accused of the misuse
of some $15 billion in emergency funds disbursed by Bank
Indonesia between 1997 and 1999. A recent IMF-sponsored audit
found that $9 billion remain unaccounted for.

Yet the IMF, in a farcical defense of the principle of central
bank independence, actively resisted the government's efforts to
remove those responsible. Although this may be puzzling to
outsiders, Indonesians view the Fund's position as a natural
consequence of the close working relationships developed over the
years between IMF and Bank Indonesia staff.

An independent panel consisting of two members appointed by
the government and two by the IMF recently submitted proposals
for revision of the Central Bank Law designed to make Bank
Indonesia more accountable. The adoption of the proposed changes,
however, will not resolve the dispute unless the IMF also agrees
to stop meddling in the government's attempts to clean up Bank
Indonesia.

The IMF is also at odds with the government over interest
rates. Anoop Singh, the Fund's deputy director for Asia and
Pacific, argues "it is crucial to maintain a tight monetary
stance until inflation risks have been firmly contained, and for
Bank Indonesia to act flexibly and preemptively for this
purpose."

The IMF's friends in the central bank have heeded his advice,
raising the rates on its benchmark SBI securities six times in as
many months.

But is this tight money policy really necessary? Consumer
prices are only rising at about 10 percent per annum, levels
comparable to those of the Soeharto era when the IMF routinely
praised Indonesia for its conservative macroeconomic management.

In the context of a slowing world economy, excess domestic
industrial capacity, mass underemployment and a fragile banking
system, moderate price inflation is the least of Indonesia's
problems.

But even if inflation were a genuine concern, higher interest
rates would do nothing to address it. Far from overheating, the
Indonesian economy is still struggling to regain its footing
following a depression of historic proportions.

More than anything else, Indonesia's mild inflation is due to
the weakening rupiah and the resulting price effects on imported
raw materials, intermediates and consumer goods. The persistent
downward pressure on the currency is obviously caused by
recurrent bouts of speculation following episodes of political
instability and communal violence.

The deteriorating relationship between the government and the
Washington institutions has been singularly unhelpful from this
perspective.

As in the early stages of the financial crisis, the Fund is
laboring under the illusion that rising domestic interest rates
will strengthen the rupiah.

This is an experiment that has been tried and clearly failed,
and there is no reason to repeat the mistake now. To the extent
that further rate increases succeed in choking off economic
activity, they are more likely to accelerate currency
depreciation rather than reverse it, much as they did in 1998.

Similarly, a sustained strengthening of the rupiah is only
likely to follow an increase in economic activity, as during 1999
and 2000.

Much the same can be said about the fiscal deficit, which the
Fund predicts will reach six percent of gross domestic product in
the absence of corrective measures.

The government and IMF are committed to reducing the deficit
to less than four percent of gross domestic product before the
end of the fiscal year. This will no doubt mean a reduction in
fuel subsidies, although the government realizes that too rapid
an increase in fuel prices is tantamount to political suicide.

Soeharto discovered as much during the April 1998 protests
when he attempted to implement a similar IMF proposal in April
1998. Even fuel subsidies are really beside the point.

Two-thirds of central government expenditures go towards
servicing international and domestic debt. This means that the
size of the deficit is extremely sensitive to domestic interest
rates and the value of the rupiah against the US dollar and
Japanese yen.

For example, every one percent increase in interest rates adds
Rp 2.7 trillion to the budget deficit, mainly in the form of
higher payments on government bonds issued to bail out the
banking sector.

Similarly, a 10 percent depreciation of the rupiah adds Rp 3.8
trillion to international debt service payments. These two
factors together account for the difference between the
government's projected and target deficit for the current fiscal
year.

Economic growth is the only viable solution to the deficit
problem. In contrast to the IMF plan, monetary policy should
provide a mild stimulus as a means of encouraging investment,
increasing demand for the rupiah and boosting domestic demand.

This would also have the positive effect of immediately
reducing domestic debt service obligations, providing some relief
for government finances.

The IMF could make an important contribution to this process
by dropping its insistence on excessively tight money and
reaching an agreement with the government over issues such as
central bank independence and the orderly disposal of government
assets under government control.

A flexible partnership with the IMF would do much to reassure
nervous investors and would probably result in an immediate
revaluation of the rupiah and a reduction in political tensions.
A positive role for the IMF would require the kind of political
will shown by the organization in Turkey, where a new $10 billion
IMF bailout program was agreed in principle as negotiations with
Indonesia broke off at the end of April.

As the ink dries on this deal, Turkey's third in six months,
Indonesians will ask whether economic distress in their country
ranks as highly on the IMF's agenda as that of NATO's ally on the
edges of Europe.

At the moment, the answer appears to be that it does not.

Help for the Abdurrahman government has fallen off the agenda
in Washington, both in the United States Treasury, and, by
extension, the IMF. From this perspective, the Fund's
inflexibility in Indonesia has more to do with Washington's
strategic calculations than with right and wrong.

The writer is lecturer in economics at the School of Oriental
and African Studies, University of London.