Structural reform lagging

Indonesia has come a long way in reforming its economy, which has been battered since 1998 by the multidimensional crisis amid the transition from a centralized, authoritarian government to a decentralized, more democratic one.

A more consistent implementation of reforms has been strengthening macroeconomic stability, as can be seen from the steady decline in both interest rates and inflation. Fiscal consolidation is continuing and the ratio of government debts to gross domestic product was down to as low as 72 percent from more than 105 percent in 2001, plus the rupiah has kept its strength against the American dollar.

The economy has reduced its vulnerability to both domestic and external shocks, such as the terrorist bombings in Bali last October and the recent war in Iraq. Banks have been decreasing their nonperforming loans, while financial restructuring has cut down the gearing ratios in business enterprises.

Unfortunately, though, there are few signs that the stronger macroeconomic stability has been fueling higher growth. In fact, growth this year is widely predicted to be less than 4 percent, as it was in 2001 and 2002. This is way below the minimum 6 percent expansion needed to absorb the estimated 2.5 million new job seekers entering the labor market annually, let alone the millions of others who lost their jobs at the height of the crisis in 1998 and 1999.

Moreover, most people do not have strong confidence in the long-term outlook of the economy and are concerned that the current stability is still fragile. Just witness how almost 50 percent of the Rp 833.4 trillion (US$93.6 billion) in private savings in the banking system as of March consisted of time deposits of one- to three-month duration, and almost all of the capital that has begun to flow in was portfolio investment that could immediately fly out simply at the first hint of any trouble.

What fundamentally went wrong?

Analysts and businesspeople blame the persistently low growth on the long backlog in structural and legal reforms that has kept the environment inimical to new investment, while private consumption, which has been the main locomotive of the economy since 2000, has been losing steam due to lack of savings and mounting consumer debts.

Most structural reform has largely been behind schedule due to a combination of strong resistance from vested interest groups within the government, poor leadership within the executive branch, adversary relations between the executive and legislative branches and inadequate institutional capacity to execute reform.

Most damaging is the miserable failure in corporate restructuring due mainly to the bombed-out system of bankruptcy proceedings under the prevailing Bankruptcy Law.

Unreliable bankruptcy proceedings have distorted market competition as errant firms that have simply stopped servicing their debts have an advantage over those that painstakingly endeavor to service their debts.

Yet more damaging to the long-term foundation of sound economic growth is the loss of opportunity created by the economic crisis to clean up the corporate sector from the inefficient businesses that in the past thrived mostly on the benefits of corruption or collusion and nepotism.

Consequently, most banks remain highly averse to new lending, which is badly needed to fuel a higher pace of economic activities.

The political environment for making decisions about the remaining reform measures has become increasingly tough as the House of Representatives has always insisted on delving into the nitty-gritty of every executive action. This is actually expected in a democratic and decentralized Indonesia. Gone are the days when policies could simply be decreed and implemented under the sole command of the president. Decision- and policy-making should now be based on a national political consensus. That is what democracy is all about.

The problem though is that a balancing act is badly needed to accelerate the pace of structural measures to stimulate investment, because the nation cannot afford a few more years of low growth without risking the huge unemployment figure exploding into social and political instability and the incidence of poverty rising again.

The next 18 months will be even more challenging insofar as government discipline and leadership to implement structural reform are concerned.

First, because most of the remaining reform measures are much more difficult as they involve institutional-capacity building in taxation, customs service, the legal system, local autonomy and other components of good governance that all require the transformation of old minds, culture, work habits.

Second, because the government will no longer have a reward- punishment mechanism for its reform program with the scheduled termination of the International Monetary Fund extended facility later this year.

Third, because during the 2004 election year, both the executive and legislative branches will tend to favor populist measures at the expense of the long-term good of the economy. It is therefore most imperative for both the executive and legislative branches of government to realize that without steady, significant progress in structural reform the economy will never return to the path of high growth, but will instead become highly vulnerable to a new bout of crisis.