RI needs market control

RI needs market control

By Peter Sheehan and David Ray

MELBOURNE (JP): In the months since the fall of the Soeharto
government, Indonesia has begun a remarkable political
transformation, and a new democratic nation is slowly beginning
to take shape.

But at the same time the economy has deteriorated sharply, in
spite of strenuous efforts to implement the International
Monetary Fund (IMF) program and substantial foreign support.

The food situation is very dangerous; most firms are still
paralyzed by debt; inflation is likely to top 100% in 1998; GDP
will probably drop 20% this year and unemployment is surging.
Decisive action is necessary to address these issues, or economic
collapse will overwhelm political progress.

Earlier this year (The Jakarta Post March 16) we put forward a
set of proposals to tackle the emerging crisis in Indonesia.
These proposals were based on the premise that Indonesia needed a
period of respite from open capital markets to take control of
its own affairs and to put its house in order. On this basis, the
key elements were restrictions on the capital convertibility of
the rupiah, a fixed exchange rate for current account
transactions, steps to resolve the corporate debt crisis and a
more expansionist policy.

In our view, events since March 1998 have confirmed that broad
approach, as the East Asian crisis has deepened in many countries
with open capital markets and has spread beyond the Asian region.
Many distinguished economists, such as Paul Krugman, Jagdish
Bhagwati and Joseph Stiglitz of the World Bank, have come to a
similar view.

Continued growth in China, which has a fixed exchange rate and
limited capital convertibility, has demonstrated that there are
viable alternatives to the IMF route, and recently Malaysia has
embarked on such a course of action.

The purpose of this article is to make some revised proposals
along these lines to meet the desperate economic situation which
now confronts Indonesia.

In our judgment there are four key issues that must be given
priority, although all the economic issues are now intertwined
with one another.

Food Supply. The most fundamental problem confronting the
nation is the supply and distribution of food, in particular
rice. There are increasing numbers of reports of hoarding and
smuggling of desperately needed food stocks.

Famine is now a very real possibility in certain parts of the
archipelago.

Many economic studies of famine have shown that the problem is
usually not a shortage of food, but weaknesses in distribution
systems and economic incentives which stop the available food
getting to those who are starving. This seems to be clearly the
case in Indonesia now.

In particular, with the fall in the rupiah, the import parity
price of rice has risen nearly fivefold over the past year.

Hence, with the present exchange rate, efforts to get food to
the needy at reasonable rupiah prices provide massive
opportunities for corruption and smuggling.

Inflation. Few things are more destructive of economic and
social development than high inflation. For example, sharp
increases in the price of food and other necessities have led to
significant erosion of the purchasing power of incomes, and are
fueling social unrest. Getting inflation down must be a key
priority.

Corporate Debt. The corporate sector in large part remains
crippled by the combined effect of high interest rates, higher
prices for imported inputs, falling revenues and asset values and
a huge debt overhang. In particular, virtually no progress has
been made on the US$80 billion debt hanging over Indonesian
companies.

This is in spite of the fact that foreign lenders have already
been required to make massive provisions for losses on these
loans in their consolidated accounts. The present stand-off
benefits neither Indonesian firms nor the foreign lenders.

Interest Rates. Even though inflation is high, interest rates
of 60 percent to 80 percent are destructive for both companies
and individuals, especially when neither incomes nor asset values
are rising commensurately. Much lower interest rates are vital
for economic recovery.

It is now surely clear that Indonesia needs to take decisive
action to take back control of its own affairs from the IMF and
the international markets, and to meet the desperate needs of its
people. Waiting for the markets to work, or for confidence to
return of its own accord, will be waiting in vain.

Nevertheless, this action needs to be taken in full
recognition of the difficulties and of the market realities. It
should also be market conforming as far as possible, providing a
respite from, rather than a rejection of, international market
forces.

The world climate in which such concerted national action
would be taken is quite different from that of six months ago.
The deficiencies of the IMF approach are now widely recognized,
as is the depth of the problems facing Indonesia. Appropriate
action on alternative policies, carried out carefully and
professionally, could receive widespread support from foreign
governments and agencies.

In addressing these problems the Indonesian government needs
to concentrate on a few key points. Our suggestion is that the
following five steps should be given priority.

1. Fixed Exchange Rate for Current Account and Foreign Direct
Investment (FDI) Transactions. The government should put in place
a fixed value for the rupiah, applying to all bona fide current
account and FDI transactions, including letters of credit and
other instruments directly related to Indonesia's goods and
services trade and all income and capital movements directly
related to FDI.

This value should be fixed at above that deemed necessary,
given expected outcomes for inflation and economic activity, to
ensure a current account surplus for Indonesia. As a working
premise we suggest something of the order of Rp7,000 to the U.S.
dollar. This rate would be supported by Indonesia's existing
foreign exchange reserves, but not in the form of a currency
board.

2. Restricted Capital Account Convertibility: Controls on
Capital Flows. The government should, for a period of no longer
than three years, reintroduce controls on other capital flows and
restrict the convertibility of the rupiah for capital
transactions. Exceptions should include small transactions and
all repayments by Indonesian firms or individuals of foreign
currency debt, which should be convertible at the fixed exchange
rate. In the case of firms this should be subject to an agreed
debt rescheduling package with the lender.

3. Use the New Regime to Reduce the Foreign Currency Debt
Overhang of Indonesian Firms. In the context of restricted
capital convertibility and a lower exchange rate, the government
would be in a much stronger position to force a resolution of the
debt position of companies as a matter of urgency. This could be
done by compulsory tripartite negotiations bringing together
companies, lenders and expert officials.

Participation in such negotiations should be a condition for
any Indonesian firm to receive government support, and for any
foreign lender to receive approval to convert any interest or
debt repayment proceeds into foreign currency.

The aim of these negotiations should be to resolve the problem
by an agreed process of debt rescheduling and loan write-offs, at
the new exchange rate. In limited cases, the government might
offer, through the Indonesian Debt Reconstruction Authority
(IBRA), to take over part of the foreign currency debt of viable
Indonesian firms in return for equity.

This might be applied particularly to key export-oriented
firms, or as one part of an overall package which includes a
substantial write-off of debt by the lender. Firms which are
clearly nonviable should be allowed to fail, and in these cases
international lenders should incur normal commercial losses.

4. Controlling Inflation. A central goal of policy must be to
reduce inflation from the expected 1998 figure, on present
policies, of over 100 percent to 15 percent to 20 percent in
1999. While both a higher rupiah and lower interest rates will
contribute substantially to this, IMF-mandated measures which
contribute to rising prices, or perhaps more importantly to
expectations of rising prices, should not be implemented at the
present time. The immediate priority must be the control of
inflation rather than the reduction of the cost of subsidies,
although this will be reduced by the effects of the higher value
of the rupiah on the cost of imports.

5. Lower Interest Rates. With capital flows controlled and the
exchange rate pegged, there will no longer be a need for high
rates of interest to protect the currency. Interest rates should
be reduced substantially, and should be set having regard to a
realistic estimate of the rate of inflation achievable in 1999,
rather than the expected rate for 1998.

Nevertheless, monetary policy should be held firm, to ensure
that the present burst of inflation is halted, and is not allowed
to be transmitted into a continuing period of high inflation.

Indonesia's problems are much deeper than they were six months
ago, and the case for urgent, innovative action is consequently
more pressing.

They also deeply interrelate with one another, so that
individual issues, such as the food crisis, are unlikely to be
resolved without broader economic action. Nevertheless, the aim
of each of our proposals has been to address the urgent problems
facing Indonesia, rather than to remove it from open
participation in the world economy.

As soon as current problems are stabilized and appropriate
structures and controls are in place, Indonesia should return to
the world of free capital flows and floating exchange rates.

Prof. Peter Sheehan is director of the Center for Strategic
Economic Studies at Victoria University in Melbourne. He was
Director General of the Department of Management and Budget in
Victoria (1982/1990) and adviser to former Prime Ministers Hawke
and Keating. Dr. David Ray is an economist specializing on
Indonesia at the Center.

Window: Indonesia's problems are much deeper than they were six
months ago, and the case for urgent, innovative action is
consequently more pressing.