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.