Indonesia, Australia and overcoming the Asian crisis

Former Australian prime minister Paul J. Keating, in his capacity as visiting professor of public policy, discussed the impact of the Asian economic crisis on the region in his lecture at the University of New South Wales in Sydney in March. The following is a slightly edited version of the lecture. This is the first of three articles based on the lecture.

SYDNEY: The Asian economic crisis, which began with speculators' attacks in Thailand in May 1997, is presenting Australia and the other countries of the region with a complex and dangerous challenge.

That challenge is not just economic, although the implications for individual economies, including Australia's, are serious. It is political and strategic as well.

The whole direction, in which the Asia-Pacific has been moving -- toward economic and political openness, toward a sense of Pacific community -- is at risk. It is a perilous moment and there are real questions in my mind about whether we and our institutions can meet it successfully.

I want to talk about why the Asian economies suddenly look so shaky, why the problems seem worse in Indonesia, the country of greatest immediate concern to Australia, what the implications are for our global and regional institutions, and what Australia should be doing about it.

This is the first regionwide crisis we have seen in Asia since it became one of the central pillars of the global economic systems.

Its origins will be the stuff of many future Ph.D. theses. And it will take time to untangle its roots.

No one accurately predicted its timing or its precise cadence. And no one understands with certainty whether it will spread further or how long its resolution will take.

But one of the important causes certainly lies in currency exchange rates and the impact of rapid movements of currency, which the information revolution has facilitated.

Its beginnings can be traced back to 1985. That was the year when, in response to growing U.S. concern about the size of its trade deficit with Japan, the Group of Five (G-5) industrial countries agreed in the Plaza Accord (in New York) to take coordinated policy actions to push the U.S. dollar lower. The result of their efforts, as they intended, was that the yen appreciated strongly against the U.S. dollar.

That rising yen increased costs for Japanese exporters and encouraged them to move offshore. Asia was the preferred destination, in part because the pegs that Asian governments had established between their currencies and the U.S. dollar made production costs cheap.

Over the next decade, this link with the dollar served Asian countries well. It facilitated the long boom in foreign direct investment into the region, with all the associated benefits, including technology transfer, which came with it. From the mid- 1980s, Japanese companies built as much manufacturing capacity in continental Asia as exists in France. Businesses borrowed dollars cheaply at low rates of interest, thinking that the fixed tie with the American dollar gave them a natural hedge.

But then the game changed. In the two years after 1995, the U.S. dollar rose 60 percent against the yen, dragging the pegged Asian currencies up with it. As these economies became less competitive, their current accounts were exposed to much greater scrutiny, especially as regional exports fell after 1996.

The artificiality of the dollar pegs became more obvious and devaluation became inevitable.

Stephen Grenville, the deputy governor of the Reserve Bank of Australia, recently described the crucial combination of elements in the crisis as "the large volatile foreign capital flows, plus fragile financial sectors" which made these economies very vulnerable to changes of confidence.

In effect, the pressures of growth had become too great for the inadequate structures of the Asian countries to cope with. Their economic systems lacked transparency, banks were often seriously underregulated, lending was politically directed and legal structures were inadequate.

The contagion spread with astonishing speed. In the markets, as Jeffrey Sachs put it, "Euphoris turned to panic without missing a beat."

The economies of Thailand and South Korea, Malaysia, the Philippines and Indonesia came under scrutiny, then pressure.

But nowhere has the pressure been more intense than in Indonesia, and nowhere in Southeast Asia will the consequences be more serious. The reasons, as should be so, are matters of the greatest importance to Australia.

I said as prime minister that no country was more important to Australia than Indonesia. That reality will be brought sharply home to us over the next 12 months.

Clearly, what happens in Indonesia affects Australia's prosperity and security directly. We cannot isolate ourselves from the consequences of large-scale economic, social or political uncertainty among the 202 million people living on an archipelago which stretches over 5,000 kilometers across our north.

But developments in Indonesia affect Australia indirectly as well because what happens there will determine -- not simply shape or mold but "determine" -- how quickly and peacefully the rest of Southeast Asia can develop.

This was a lesson which was clear to us more than 30 years ago, as Australians and our neighbors in the region watched with relief the transfer of power from president Sukarno to Gen. Soeharto and the establishment of the New Order government.

It is important to recall that time. Indonesia's economy was in chaos, inflation reached 1,000 percent and, as part of its policy of confrontation against Malaysia, the Indonesian government had launched attacks on its nearest neighbors. Australia was directly, if unofficially, involved in that military conflict.

The consequences of those developments in Indonesia in 1965 and 1966 have shaped Australia's environment for the past 30 years. As I have said before, the coming to power of the New Order government was the single most beneficial strategic development for Australia in the post-war years.

In abandoning the dangerous international adventurism of his predecessor, President Soeharto provided the solid underpinning for successful regional cooperation through the Association of Southeast Asian Nations (ASEAN) and later the Asia Pacific Economic Cooperation (APEC) forum.

He refocused the efforts of the Indonesian government on economic and social development. The New Order government delivered consistent economic growth of about 7 percent a year.

And, just as importantly, the growth was spread widely. According to the World Bank, poverty was reduced more rapidly in Indonesia than in any other country it has studied.

The social indicators were equally strong. Over the past 25 years, the number of Indonesians living in absolute poverty fell from 60 percent to 11 percent, infant mortality was halved and life expectancy rose by 17 years. Literacy rates were up from 39 percent in 1960 to more than 80 percent now. Economic modernization and family planning successes mean that there are some 50 million fewer Indonesians than would otherwise have been the case.

As a result of these developments, Australia was saved literally billions of dollars in defense expenditure and a market was created for trade worth A$5 billion last year.

Until this current crisis, Indonesia had been one of Asia's great success stories. In addition to a high growth rate, its current account deficit was less than 4 percent, its budget was in balance and inflation was under 10 percent.

As in Thailand, Indonesia's economic problems began when its government was unable to sustain its informal currency peg between the rupiah and the U.S. dollar. Indonesia had benefited greatly from that peg and the inflow of foreign direct investment it brought. But one of the consequences of opening up the economy was to give the financial and currency markets of New York, London and Frankfurt a significant influence on the Indonesian economy. I do not think this change was fully understood in Jakarta.

As the Indonesian economy came under greater scrutiny, problems that everyone had known about and lived with, like a weak banking sector, a lack of transparency in the economy and political direction of investment decisions, were put under the microscope.

Capital started leaving Indonesia, capital inflow slumped and confidence evaporated in the local market. The problems were magnified because an estimated 75 percent of the offshore private sector debt of about US$74 billion was unhedged.

As the rupiah came under pressure, the Indonesian government realized it did not have the resources to defend the peg. In August 1997 -- quite early in the crisis -- it decided to float the currency.

But neither that action, nor its extensive economic deregulation package in September, nor an International Monetary Fund (IMF) package in November, which the Indonesian government was praised for seeking in a timely way, were sufficient to restore market confidence.

The annual budget delivered in January had some strong points but was undermined by out of date economic assumptions, especially about the value of the currency. The government was forced back to the IMF to negotiate another, even larger, $43 billion, package of support.

This package, which was signed on Jan. 15, surprised almost all observers with its comprehensiveness. It involved extensive economic restructuring, including fundamental reform of the financial sector and the dismantling of most government monopolies. "Sweeping away all the restrictions" was the way the IMF put it.

But despite these measures, the rupiah has not recovered. From a rate of 2,430 to the U.S. dollar in mid-1997, it has dropped to a current level of about 8,000. In these circumstances, Indonesia's high foreign debt of $120 billion becomes an insupportable burden. In essence, the Indonesian government has lost control of the pace of its adjustment to the global economy.

To give some idea of what Indonesia has to cope with, the decline in the rupiah's value is the equivalent of the Australian dollar falling from 75 cents to 10 cents. No government can cope with that. The current rate of exchange is quite unreal -- a fiction which bears no relationship to the strengths of the Indonesia economy.

As the governor of the Reserve Bank of Australia, Ian Macfarlane, has pointed out "Falls of this size defy economic logic and serve no useful economic purpose ... There is no value to Indonesia, to the region or the world in now having an exchange rate at a quarter of its former level."

But Indonesia's economic problems are not confined to the financial sector. In parallel with the currency crisis, the widespread El Nio drought has brought smaller rice harvest and food shortages as well as catastrophic forest fires in East Kalimantan.

This depressed economic outlook and the impact of many of the IMF reforms will have serious social consequences. These cannot be avoided.

Fuel subsidies will be out and food will rise in prices. At the same time, the unemployment results of the currency collapse will be felt more strongly.

Official estimates, almost certainly too low, are for a 50 percent increase in the number of unemployment to 6.5 million during the course of the year.

The Indonesian economy is expected to contract by at least 5 percent this year. And inflation is already rising and is expected to hit 40 percent. Hyperinflation is possible.

These economic problems raise the likelihood of social unrest. Resentment against Chinese shopkeepers could lead to further looting and rioting with unforeseeable consequences. The leadership of the Indonesian Armed Forces is strong and competent but, in such circumstances, discipline will be tested.

This is not just a matter of foreign policy concern. It is a human tragedy. The economic decline has dashed the prospects for tens of millions of ordinary Indonesians, who for the first time had been seeing some real improvements in their lives and better hopes for their children.

Why did it happen? Why have markets punished Indonesia so much more severely than other Asian countries in demonstrably worse macroeconomic shape?

The main reason is that the future of the Indonesian economy became caught up in judgments about its political system.

This was partly unfortunate timing. The onset of the crisis coincided with what was always going to be an uncertain political period in Indonesia, leading up to the presidential election. Markets like certainty and the Indonesian political timetable meant they could not have it.

Aspects of Indonesia's own response to the crisis contributed to the difficulty. It sent out mixed and sometimes confusing messages as in the uncertainty about the currency board proposal. And it has backtracked on some important issues in the agreement with the IMF (as well as on some trivial issues which had symbolic importance internationally).

The regrettable truth is that times like this require directness and clarity rather than Javanese obliqueness.

But most importantly in my opinion, Indonesia was disproportionately punished because a grossly inaccurate view had taken hold in some quarters in Europe and North America that it was some sort of rogue state, to be talked about in the same breath as Mobutu's Zaire or Marcos' Philippines. Partly as a result of East Timor and domestic dispute over political fund- raising in the United States, Indonesia had become a symbol and a caricature rather than a real, complex and deeply important country.

Indonesia has not been good at telling its own story. It is noticeable how few voices exist in the United States or Europe willing to speak out for Indonesia -- I'm not talking about the government here but the country and people.

The result was that the international goals for dealing with the crisis, and the performance measurements against which Indonesia would be judged, were expanded and restructured to include, explicitly, wholesale economic and social reform and, implicitly, a change in the political leadership.

So the IMF's demands included not just measures to allow orderly economic adjustment but complete reordering of the Indonesian economy.

It seized the opportunity to try to impose in one sweep an extensive and intrusive program of change. Some of the reforms it demanded were badly needed and will greatly strengthen the Indonesian economy when it recovers. But the fund has made that recovery more difficult by changing Indonesia's political dynamics and imposing goals which were politically unachievable, and therefore' delaying any restoration of confidence.

It is important to remember that despite Indonesia's rapid growth, it remains a developing economy with serious problems of administrative efficiency -- just in getting the government's writ to run, it ought not to be surprising if it has run into difficulty implementing a complex package of reforms which I doubt that Australia, with a smaller population and better communications, could have put in place in two months.

It was noticeable that almost before the ink was dry on the January agreement, prominent voices in the United States and Europe were casting doubts on Indonesia's willingness to comply. This had elements of a self-fulfilling prophecy about it. It undercut, almost immediately, the very confidence the measures were designed to restore.

Some of the commentary we are seeing about Indonesia has a chilling tone to it. Those who argue that the screws should be tightened on President Soeharto and the government because this will somehow force political change show tragically little understanding of what the consequences of widespread unrest in Indonesia would be for real people in the real world.

The IMF has done its job with good intentions, but I agree with those who argue it has been the wrong job. Or perhaps the right job, but in the wrong time and manner.

I am certainly not arguing against further reform. I fully agree with the need for greater transparency and economic and political openness. This is a line I have pressed in APEC and around the region.

The immediate need, however, is to stabilize the rupiah and get it back to a figure in the vicinity of 5,000 to the U.S. dollar.

This cannot be done without wholesale reform of the banking and finance sectors, and the satisfactory rescheduling of Indonesia's corporate debt. But it does not require the immediate dismantling of the above monopoly, however worthy a goal that might be.

The essential requirement is to get confidence back into the investment community, both domestic and international.

To do this Indonesia has to directly address the question of the private debt owed to overseas creditors. So long as this issue is unresolved, solvency will not be restored to the bulk of the corporate sector and the rupiah will continue to hover at unrealistically low levels.

In part, this might be done by the large Indonesian companies converting debt into equity, or at least acknowledging that even at any reasonable exchange rate, the corporate debt will still be too high and will require dealing with. A move along these lines would help confidence in the rupiah.

The new government has already announced plans to restructure its 164 state-owned companies and has foreshadowed the development of strategic partnerships with foreign firms. It will find benefits in moving speedily on this front.

But under the best circumstances imaginable, it will be a long, tough road to recovery in Indonesia.