Policies must put people first

This article is based on the executive summary of a report on the Indonesia Economic Crisis meeting held at the Australian National University (ANU) in Canberra from Nov. 23 to Nov. 25, 1998. The conference was jointly initiated and designed by Prof. Anwar Nasution, dean of the School of Economics, University of Indonesia, and Prof. Ross Garnaut from the ANU.

CANBERRA: The unraveling of the Indonesian economic and political situation in the past 12 months has been overwhelming. It has cast a long shadow over the country and its neighbors.

The crisis faced by Indonesia continues to run on parallel and interdependent tracks of economic and political uncertainty. A wide range of outcomes is possible, from the optimistic to the pessimistic.

Progress toward economic stabilization and recovery will be difficult -- some would say impossible -- to achieve without resolving vital political issues.

On the other hand, the necessary transition to democracy and increased participatory processes will also take time, and the reforms needed to achieve stability, and the beginnings of a recovery cannot be delayed.

The crisis has also torn, quite seriously, the social fabric and cohesion of Indonesia. Both the political and economic agenda must be based on a renewed and explicit social contract, which addresses systematic inequities and concentration of economic and political power, and is inclusive of all members of society.

Although it is difficult to forge ahead on economic stabilization and recovery under conditions of political uncertainty, there is no real alternative. It has to be realized that economic stability and recovery will be essential to permit a reasonably orderly transition process and to ensure that desirable political outcomes are achieved.

For the restoration of economic growth, it is, therefore, crucial and urgent that policymakers agree on and prioritize economic reforms. They will also need to adopt and adhere to clear and consistent principles for reform and to be aware of the need to sequence the timing of the policy changes.

It is equally important that the policies adopted should be mindful of the sociopolitical parameters and challenges facing Indonesia at the present time.

While the political outlook is still uncertain, 12 months after a drastic collapse in domestic demand and the financial sector, there are tentative signs of economic stability and turnaround by November 1998.

* The exchange rate has improved significantly from the destabilizing rate of Rp 15,000 per U.S. dollar in June.

* Inflation has eased substantially and expectations were for a continued decline.

* Nominal interest rates have begun to fall: The rate on one-month Bank Indonesia promissory notes (SBI) dropped from 70 percent per annum in the first week of September to 50 percent in the third week of November.

* The monetary policy has been successful in absorbing liquidity, and the budget deficit for the current year is expected to be lower than targeted.

The social impact of the crisis has been great in terms of falling real wages and incomes, greater unemployment and poverty.

However, recent analysis suggests that initial estimates of the damage have been overly pessimistic. Increased poverty is serious but not an insurmountable problem, and some regions outside of Java, notably Sulawesi and Sumatra, have enjoyed export booms and better socioeconomic conditions than those of Java.

These are important and welcome signs. They confirm that there is potential and a basis for economic recovery in Indonesia. At the same time, we must not become overly optimistic that the turnaround will continue without considerable further policy effort. Large risks and potential fluctuations in economic conditions still lie ahead.

The most urgent priority is to sustain the recent trend toward macroeconomic stabilization. This should be achieved in the short term by continuing the current approach of flexible exchange rates, targeting of base money and maintaining a stimulatory budget.

The budget will need to be stimulatory for the next few years to offset the collapse in private demand and to protect vulnerable groups through social safety net programs. The effectiveness of the social safety net needs to be ensured through well-designed and targeted programs.

These will need to be based on clear priorities of the target groups, thus minimizing the budgetary burden.

Other components include placing sunset clauses on subsidies or special treatment, avoiding the entrapments of populist policies and prioritizing needs for government support for bank restructuring.

Government spending should remain subject to fiscal discipline, mindful of potential inflationary effects that would, in turn, affect the monetary targets.

Some revenue may be raised from the disposal of some state- owned enterprises, but significant budget deficits are unavoidable in the next few years. Noninflationary financing of these deficits will be possible only with substantial external support.

Significant additional external funding and assistance will be needed for the next few years. Government revenues will be below precrisis levels (in real terms) and the funds committed under the IMF emergency package were front-loaded for this fiscal year.

These will taper off in early 1999. The recently announced $30 billion Miyazawa Plan for East Asia, and the joint commitment of United States and Japanese leaders to support financial restructuring in the region, are very welcome developments in this context. But it also needs to be recognized that Indonesia will be one of several economies that will compete for such additional sources of support.

Beyond stabilization, there are two priorities to restore growth.

First, there is the issue of restructuring of banking and the corporate sector. It is clear that public funds will be needed to restructure the banking sector. The most urgent need is to recapitalize the better banks so that normal banking activities can be resumed as soon as possible. A range of other issues need to be addressed in an open and transparent framework, with due consideration to the principles of justice and distribution. These include dealing with the problem banks, nonperforming loans, asset management of owners of the banks and of debts to pay back the government.

The same principles apply to corporate debt restructuring, which will need to be backed by effective bankruptcy procedures.

External assistance will also have an important transitional role by providing funds to alleviate risk. This might be achieved through guarantees or underwriting to reduce perceived risks and costs of export financing or bonds issued by the Indonesian government.

The second priority is to accelerate export growth. The large devaluation of the rupiah has led to a substantial improvement in Indonesia's competitiveness, although the export response has been limited.

More needs to be done to remove administrative problems and to supply adequate working capital for potential exporters. Exporter and other producer costs can be reduced by further trade liberalization.

The large "natural" protection provided by the low exchange rate makes this a good time to lower trade barriers without a significant short-term impact on domestic producers.

An acceleration of trade liberalization by Indonesia could prove very important in ensuring the necessary resurgence of exports is not blocked by renewed protectionism on the part of importers.

Economic growth must also lead to a perceived trend toward improved greater equity. Measures to ensure this can be, and need to be, economically sound as well as politically acceptable.

While direct subsidies targeted to overcome poverty are an important part of the policy response to the crisis, the strengthening market mechanisms is a critical element in the promotion of equity. Specific initiatives should include:

* maintaining and improving communications and transportation links;

* dismantling monopolies;

* reducing administrative controls to internal trade; and

* reducing high transaction costs facing small and medium enterprises.

In the new political environment, it will be difficult, but important, to ensure that measures which are supposedly designed to promote equity are not political favors to selected groups. These can damage economic stability and jeopardize incentives and growth, without bringing about any real reduction (and possibly even some increase) in poverty or inequality.

These are the most urgent priorities. But many more issues will also need to be addressed in the next few years. One challenge is to ensure that the momentum is not lost in augmenting social overhead capital.

In addition, there will be a need for substantial investment in human resources to improve the institutional capacity of agencies entrusted with implementing and monitoring policies for recovery and reform.

One of the most important needs for capacity-building is to ensure that Bank Indonesia (the central bank) and other relevant agencies are able to safeguard the future soundness of a restructured financial sector.

Some of the many economic matters that need attention are set out in the body of this report. The institutional capacity for reform is limited and prioritization is of critical importance.

However, to sustain economic stability and recovery, it is important to begin to think through medium-term policy options.

Above all, it is crucial that an equitable policy framework for economic management be designed by Indonesians, and the reasons for policy choices be explained to and broadly accepted by Indonesian society.