Indonesian economy muddles through adverse conditions

Indonesian economy muddles through adverse conditions

By Vincent Lingga
The Jakarta Post
Jakarta

Indonesia's economy entered 2001 amid heightened political
uncertainty, the increasingly erratic leadership of then
president Abdurrahman Wahid, a decline in the government's
credibility and a weakened global economy.

The government's relationship with the International Monetary
Fund (IMF) became prickly after the IMF decided in December 2000
to postpone the third US$400 million disbursement of its extended
loan facility due to frequent slippages in promised reform
measures and several policy reversals.

The World Bank delivered another blow to the market's already
low levels of confidence in the country's economic prospects by
deciding in January to slash its annual loan commitment from $1.2
billion to a mere $400 million, citing the government's huge
existing debt burden as the main reason for the new lending
policy.

However, the real reason was the government's failure to keep
up with its reform commitments, particularly those related to the
establishment of high fiduciary standards in budget management
and procurement systems, and its anti-corruption drive.

The cash-starved government received further punishment in
April when the World Bank canceled the disbursement of $300
million in social safety net loans due to what it considered the
slow pace of meaningful changes in government institutions and
the bureaucratic culture. But what really motivated the
cancellation was the Bank's heartfelt concern that the funds
would be wasted through corruption.

The nasty combination of a weakening currency, growing budget
deficit, increasing inflationary pressures and consequently
rising interest rates, along with a slump in exports, stifled the
recovery process, which began promisingly in 2000, generating a
respectable 4.8 percent growth rate.

Predictably, barely three months into the 2001 fiscal year,
official assumptions on key economic indicators, including 5
percent gross domestic product growth, inflation of 7.2 percent,
an average rupiah rate of 7,800 to the dollar and the central
bank's benchmark interest rate of 11.5 percent, were soon
rendered irrelevant.

The government and the House of Representatives eventually
agreed in June to revise the key economic assumptions to 3.5
percent GDP growth, an average exchange rate of 9,600 rupiah to
the dollar, an average interest rate of 15 percent and a 9.3
percent inflation rate.

The GDP growth rate plunged from 5.2 percent in the last
quarter of 2000 to a mere 1.81 percent in the first quarter of
2001, and slowed to 4 percent on a year-on-year basis. As market
confidence in the economy worsened, the rupiah crashed to 31-
month lows of more than Rp 11,500 to the dollar in April.

As the confrontation between then president Abdurrahman and
the House grew more intense between April and June, with
Abdurrahman resorting to threats, intimidation and political
blackmail in a desperate bid to cling to power, the economy
entered what the World Bank described in January as a "muddle
through" scenario.

The Central Bureau of Statistics came up with an even gloomier
picture for the second quarter, putting GDP growth at 0.09
percent on a quarterly basis and at 3.52 percent on a yearly
basis.

Muddle through was precisely what the economy did during the
year. A modicum of macroeconomic stability was maintained, but
economic hemorrhaging continued to weaken the recovery as most
reform measures fell behind schedule.

The economic outlook did not improve significantly even after
the nation resolved its political crisis peacefully in late July
by electing Megawati Soekarnoputri as the new president and
Hamzah Has as her deputy.

The third quarter did record a higher growth rate of 2.38
percent on a quarterly basis and 3.47 percent on a yearly basis,
thereby bringing the cumulative expansion during the first three
quarters to 3.3 percent. This led to a great deal of optimism
that annual growth would likely reach the revised projection of
3.5 percent.

But that growth was still far from the minimum 7 percent
expansion needed to absorb the 2.5 to 3 million new job seekers
who enter the market annually, not to mention the tens of
millions already made jobless by the economic crisis.

Moreover, with annual growth of between just 3.3 and 4
percent, the country may need six or seven years to return to the
level it was at prior to 1997, given the 14 percent contraction
in 1998, almost zero growth in 1999 and an expansion of 4.8
percent in 2000.

The hopes for a more rapid pace of reform that accompanied the
election of the new president were soon dashed, even before the
Megawati government passed the traditional honeymoon period of
its first 100 days in office.

Despite her unanimous election by the People's Consultative
Assembly, and even though her political party was the single
largest faction in the House, her government failed to secure
full legislative support for accelerating the reform program.

The new government did act quickly to mend ties with the IMF
with the signing of a new reform agreement in August, followed in
September by the third $400 million loan disbursement, which had
been held up since January.

But the IMF's endorsement of the government's reform program
failed to restore market confidence, as the core elements of the
economic crisis management process remained bogged down in
politics.

The House simply failed to comprehend the economic logic of a
faster pace of asset recovery and privatization of state
companies. It instead harbored a misguided nationalistic
sentiment against foreign investors acquiring assets in the
country, fearing that foreigners would come to dominate the
national economy.

The economic outlook became even gloomier after the Sept.11
terrorist attacks on the United States. The tragedy drove the
American economy deeper into recession and consequently further
weakened global economic conditions.

The country's economy was abruptly deprived of its main
driver, the export market, which together with private
consumption had become the engine of Indonesian growth last year.

Worse still, inordinately emotional anti-American street
demonstrations in several cities in September and October
projected such a horrifying image that Indonesia, for some time,
appeared to the outside world to be a country controlled by
radical Muslims. Even though the voice of reason eventually
prevailed, the damage to Indonesia's image had already been done.

Obviously, not only Americans but also quite a number of other
expatriates were scared away. Many importers in the U.S.,
Indonesia's single largest market, abruptly canceled orders,
fearing delivery problems.

Sadly, too, many foreign buyers, who had played a vital role
in helping Indonesian exporters gain a foothold in overseas
markets, decided to cancel their regular visit programs.
Consequently, Indonesian exports, which had began to decline in
the first quarter due to the weakening of the U.S. and Japanese
economies, suddenly plunged, falling by almost 17 percent in
September alone.

Minister of Industry and Trade Rini Soewandi estimated early
last month that the country would be lucky to record $42 billion
in non-oil exports this year, compared to $47 billion last year.

The worsening levels of market confidence drove the rupiah
down further, to almost 11,000 to the dollar in October and
November. This exacerbated inflationary pressures, making it even
more difficult for the central bank to lower interest rates and
rendering the overall economic environment increasingly inimical
to sound banking operations.

Significantly cutting interest rates amid the severe
depreciation of the rupiah, which was called for by many
businesspeople and some analysts, would not only have jacked up
inflation but would also have prompted a shift to dollar
positions.

Even more worrisome were the government's severe cash-flow
problems caused by lower than predicted revenue receipts and
higher than budgeted spending programs.

Actual revenues are likely to be well below the official
target because asset sales, debt restructuring and privatization
of state companies have been much slower than expected due to
excessive interference from the House and adverse market
conditions.

Worse still, foreign creditors have held up almost $1.7
billion of their $2.6 billion program loans pledged to the 2001
budget due to the government's failure to significantly cut
interest rates, combined with its low success rate in meeting
reform commitments.

Moreover, actual spending may overshoot the budgeted total
because the rupiah rate has been much lower, and interest rates
much higher, than the levels assumed by budget forecasts.

Hence, the economy has been deprived of sorely-needed
investment as the private sector, burdened with bad debts, cannot
provide the necessary stimulus, while foreign investors remain
jittery about the country's economic, political and security
conditions as well as its legal system.

The banking industry, which had been restructured and
recapitalized at a total cost of about $65 billion, is still too
weak to significantly expand corporate lending.

There is indeed a lot about the short and medium-term health
of the economy that should be cause for concern, especially with
the deadweight cost of the public sector's debt overhang, which
has reached as much as 120 percent of GDP.

It will therefore be almost impossible for the economy to grow
even by a mere 3 percent next year in the absence of a new
rescheduling package for foreign debts maturing within the next
three years and without speedier asset recovery, corporate debt
restructuring and privatization of state companies.

Asset sales and privatization are now the most promising
source of the new private capital flows that are needed to
restore investor confidence in the economy, in view of the
overcapacity present in almost all manufacturing industries. And
foreign investment, at least over the next two to three years,
will be the lifeblood of economic recovery.

But many reform measures have simply failed to materialize,
even under strong pressure from the IMF, World Bank and other
foreign creditors, which tie their loans to policy reform.

The greatest lesson the government should draw from this
utterly inept performance is that a faster pace of reform is the
key to a sustainable economic recovery.

However, reform can be sustained only by a strong consensus
between the government and the House and not by the force of
foreign aid or loans because reform requires changes in
coalitions, in ideas and in interests.