Indonesia's inflation culprits

By Mohammad Sadli

JAKARTA (JP): The Indonesian economy is growing well. The official figure last year was 7.3 percent, but the Central Bureau of Statistics has recalculated the time series for the 1988 to 1993 five year development plan with respect to real economic growth and produced the astonishing figure of an average of 8.3 percent. The previous figure was 7.1 percent.

The same growth figures were used but the base year for relative prices was shifted from 1983 (earlier time series) to 1993. Such a change in base year is appropriate and legitimate as time progresses. What influenced the outcome was the fact that oil prices in 1983 were two times higher than in 1993. What prices should be regarded as normal now? Those in 1983 or 1993?

For the 1990s, the 1993 prices should definitely be regarded as normal. But Indonesian economists are still at a loss to explain the high growth achieved during the five year development plan. This new average growth figure approaches the performance of our neighbors, Malaysia (9 to 10 percent a year) and Thailand (8 to 9 percent), and we know that their higher growth has been the result of higher savings (over 30 percent of GDP) and investments. The Indonesian saving rate is estimated at 27 percent and the normal current deficit is 2 to 3 percent of GDP.

A 8.3 percent growth rate with about 30 percent of GDP is pretty impressive. With an implicit Incremental Capital Output Ratio (ICOR) -- the ratio of investments over growth in percentages GDP -- of 3.6. Professor Sumitro Djojohadikusmo and others have lamented the inefficiency of our investment and growth process because the then perceived ICOR was well above four and exceeded five at times.

The trend in this investment-to-growth ratio has declined since the 1968 to 1973 five year development plan. This period was one of economic reconstruction and necessary frugality but those early investments produced an 8 percent growth rate. Economic growth rates dropped in the second five year development plan to 7 percent, 6 percent and then 5 percent, although the oil boom and the Inter-Governmental Group on Indonesia aid -- not yet burdened by high debt-service payments -- allowed the government to engage in heavy spending for infrastructure and large scale industries (steel, refineries and petrochemicals).

Since the middle of the 1980s this investment pattern has changed drastically. Deregulation made the economy more competitive and non-oil exports began to grow. Government investments slowed and private investment soared. Visible evidence is the skyline along Jl. Sudirman and in Kuningan.

Since the mid 1980s the economy has gained new, structural strength. The high growth sectors, such as manufacturing and modern services, are overtaking traditional agriculture (not horticulture and the new plantations which are growing fast). If these new sectors hit double digits while the old sectors only manage 3 percent a year, the overall growth could be in the 8 percent range. Base year prices of 1993 will give the relative size of the non-oil and non-food sector an additional boost.

Hence, the economy is on a new growth trajectory and can continue to grow at a speed of 8 percent a year. But the government appears less confident and has upped the new target rate for the sixth five year development plan from 6.5 percent a year to 7.1 percent.

Conservatism is a virtue, but can sometimes mislead policy. The case of cement is an illustration. The old estimates of growth of consumption have proven wrong: Too conservative? But licenses for new investment were given on this basis, in an effort to protect the industry from over capacity. The results have been periodic shortages, accentuated by efforts of price control under inflation.

Everybody was unhappy: the contractors, the public, the House of Representatives, even the government. And every one had their own favorite scapegoats: the public and House blamed the poor conglomerates, the conglomerates blamed the wholesalers and distributors, the government blamed the speculators, while the minister of industry at one point confessed that the previous statistical figures were unreliable.

If the economy really has gained new strength, why is there often a lack of confidence inside and outside the country?

First, every one was jittery because of the non-oil exports growth rate decline, primarily for plywood and textiles. On the other hand, imports kept rising. In June 1995 there was even a deficit. Structurally, merchandise exports should show a surplus to compensate for deficit in services. Fortunately, the latest figures for July indicate a surplus again. Alarmingly the surplus is shrinking.

The normal current account deficit of US$ 2 to 3 billion will be exceeded by 100 percent this year. Are lights turning red? Or only blinking yellow? For a single year, or maybe two, a current account deficit of US$ 5 billion may not be a sign of impending danger if it is a reflection of large inflows of productive investments.

This may well be the case, but the flow of footloose non- equity funds attracted to "emerging markets" and the high interest rates in Indonesia give the central bank a big headache. Because of the completely free foreign exchange regime these flows cannot be censored and sterilizing them through Bank Indonesia's Deposit Certificates carry a heavy interest burden, under which a normal commercial bank would collapse. The large capital inflows tend to appreciate the rupiah, but on the other hand the close to ten percent domestic inflation requires depreciation of the currency to keep non-oil exports competitive. If Bank Indonesia tries to outsmart the currency speculators it could put itself into a bind.

High international indebtedness is another source of weakness. Malaysia, Thailand and even China, can afford larger current account deficits because they still do not have a high debt overhang. Indonesia does not have much leeway. The last World Bank Jakarta office chief economist, Hanson, and the recent Pacific Economic Cooperation Council conference in Beijing, warned that Indonesia should control its international debt.

Monetary authorities, the finance minister and the governor of Bank Indonesia, understand this too well: But what instruments should be used? The main instrument deployed by Bank Indonesia is high interest rates, but critics (Mari Pangestu for one) warn of overuse. On the other hand, even private sector mega-projects are still sanctioned in high government circles. The proposed 500 meter television tower is the latest example.

External debt management therefore needs real political commitment and the monetary authorities can't only resort to traditional monetary policy means; effective arm twisting of the private sector is also in order.

Lastly, the near double digit inflation is an additional weakness in the economy. Because the economy is growing fast on the strength of investments and consumption, the management of inflation becomes much more crucial. Otherwise pressure on the balance of payments will assume crisis proportion.

Like in China, where inflation is even higher, the culprit may be bottlenecks in the system. Some of these are non-physical and can only be removed by deregulation, although the effect may take some time. That is why the sooner deregulation is implemented the better. Food distribution and the agriculture sector should come first.

The traditional culprit of high inflation is unrestrained money supply expansion. Money supply should not expand by over 12 percent a year. It has been at 20 percent in Indonesia. The government's budget already contradicts itself. Therefore the inflation culprits are the private banks and extra-budgetary spending.

The writer has been a cabinet minister several times.