Indonesian courts create unemployment.

Sebastiaan Pompe IMF Resident Legal Advisor Jakarta

It is accepted theory that reliable law enforcement and legal certainty are critical for investment recovery. This has been a mantra of international donor organizations for almost a decade. For Indonesia, it was reiterated recently by prominent international journals such as the Asia Wall Street Journal and The Economist, which in a recent issue says that "the culture of legal confusion...is by far the biggest obstacle to investment".

It seems that this accepted theory of international agencies is not shared by the Indonesian judiciary. In a recent debate, some senior judges took the view that courts do not play a role in this "legal confusion", and share no responsibility for economic recovery or employment.

In their view, economic recovery and employment are a matter of economics, or politics perhaps. To the extent that the law is involved at all, it is the legal system broadly speaking, the statutory framework, the administration, legal professions and so on. The courts have a passive role at best and basically just confirm the situation as they find it, so the judges argued.

Indeed, some judges said that the judiciary in reality actually protects employment where it can, such as in bankruptcy cases. They argued that since bankruptcy causes unemployment, courts therefore should apply bankruptcy law restrictively.

If judges grant bankruptcy petitions, and courts act effectively in liquidating bankrupt companies (or even in debt restructuring), they stimulate unemployment, and hence go against the national interest, it is said.

This view is misguided. Judges play an important part in strengthening the economic climate and conversely, court failure boosts unemployment. Let me set out some points here, specifically in relation to bankruptcy.

o First, effective bankruptcy law helps improve employment. Assuredly, bankruptcy cannot be described as a pleasant affair for the individual company. It involves a liquidation of assets, which is a legal euphemism for a process by which estates are broken up, assets are divided and sold off, and employees are laid off.

For the individual company, the individual manager or shareholder, and notably the individual employee, bankruptcy can be a nightmare. It is important to keep that in mind, particularly for courts, and not to rush into bankruptcy imprudently, or grant spurious claims.

Yet it also is important to lift the perspective beyond the individual case, and consider how bankruptcy impacts on economic structures generally. In this broader economic sense bankruptcy is a form of re-distributing assets.

It is the mechanism by which assets are released from dead- ends, which allows them to be invested elsewhere in more profitable undertakings. This orderly redistribution of assets stimulates economic activity, and supports employment. Effective bankruptcy therefore is a critical ingredient to an efficient economy in which employment is maximized.

This helps explain why in countries such as the U.S., Japan or in Europe, economic growth and bankruptcy are not mutually exclusive. Even a small country such as the Netherlands has on average 630 court-imposed bankruptcies monthly. The Dutch figures are more than 20 times the annual case load in Indonesia. The Indonesian bankruptcy figures are quite outrageous, and point at significant institutional and economic inefficiencies.

o Second, there is in fact a major demand for bankruptcy services in Indonesia. Some Indonesian judges, pointing at the very small number of bankruptcy cases filed in 2003, argue that their services are no longer required, that they have basically completed their job. Some of them even say that the commercial court has outlived its usefulness. This misreads the situation entirely.

The argument ignores official figures that show that a very large number of Indonesian companies collapse outside bankruptcy. According to the official statistic bureau (BPS) more than 1600 officially registered Indonesian companies (10 percent of the total) either scaled down operations dramatically or closed their doors entirely in 2002. (These are officially registered companies, the figure of unofficial unregistered companies is much higher.)

In the slow-motion and often incomplete collapse of these 1600 companies, their capital more often than not remains tied up in the company one way or the other. Until it is freed, it cannot be reinvested elsewhere; and it cannot serve to create new employment.

The inability of these 1600 companies to go through an orderly liquidation impairs the recovery of capital through for new, more profitable investment. Employment recovery is handicapped accordingly. Thus, BPS reported that the 2002 company collapse caused an additional official registered unemployment of 145,000 persons; plus possibly half a million indirectly unemployed.

Unlike asserted by some Indonesian judges, BPS figures demonstrate that there is in fact a major demand for bankruptcy in Indonesia. The question is why such cases are not brought to court. This has everything to do with the failure of the courts to give a reliable, efficient and effective service. The judges are wrong to hold that the problem is out there and that to the extent that it affects them, they have solved it. In reality, the problem is with the judges themselves.

o Third, unreliable courts boost unemployment. Courts that are unreliable, inefficient, and ineffective will encourage bad behavior in society. The worse courts are, the worse debtors will be also. They will not pay their debts in time, they will default intentionally, and will refuse to discuss alternative ways of resolving disputes -- all because it is so easy and there is no effective sanction. This is damaging to an economy, and to employment. It is damaging on society at large.

The European Union some time ago completed a study on the impact of court efficiency and intentional defaults on employment. It demonstrates that as court inefficiency increases, so do the number of intentional defaults, resulting in increased company collapses and increased unemployment figures.

This is very much the story of Indonesia in recent years, namely of how court ineffectiveness has boosted intentional default beyond all proportions, and unemployment is shooting off the charts as a result.

The misguided judicial focus on protecting debtor companies fails to grasp that this in reality is a damaging and counterproductive approach: It undermines the enforceability of contracts, and ends up damaging the entire market. Sound Indonesian companies or Indonesian banks have been dying because outstanding debts are not repaid. As these cannot be recovered through the court system, intentional defaults multiply, and employment dies.

Despite the large number of company collapses in Indonesia over past years, bankruptcy is little used in Indonesia. The reason is that the courts are unreliable, inefficient and ineffective. Capital remains tied down in dead-ends as a result.

Because it cannot be reinvested elsewhere, the resulting economic inefficiency increases unemployment. Court unreliability, inefficiency and ineffectiveness encourage intentional defaults, which boost unemployment further. In sum, courts directly contribute to unemployment in Indonesia.

The views expressed in this article are his own and do not in any way reflect those of the IMF.