Suggestions to beat RI crisis

By Peter Sheehan and David Ray

MELBOURNE (JP): The negotiations between the Indonesian government and the IMF seem to have broken down, and Indonesia may now face further falls in the rupiah and in the economy, together with surging inflation. With the crisis moving beyond the economic realm, there is now a threat of serious social and political instability, of a kind not seen throughout the archipelago for three decades.

This note makes some suggestions about a possible course of action in the face of this serious and continuing crisis. While entirely our own views, these suggestions arose out of two major conferences held early this month in Melbourne and Sydney, addressed by leading Australian economists, business spokesmen and officials.

These suggestions are based on the premise that the major cause of the East Asian financial crisis was the massive inflow of private debt and portfolio equity capital into several countries over 1993-1996, and the attempted reversal of much of those flows when investors panicked in the second half of 1997. Subsequent to the devaluation, many Indonesian firms are left with very large debts, dominated in foreign currency, and or are unable to acquire vital imported inputs at the current exchange rate.

These are the central problems which must still be addressed.

These suggestions are based on five principles.

1. Proper Assignment of Instruments. A key element of any successful strategy is that it assigns instruments to targets which they can achieve, and in particular addresses immediate problems with instruments which can have immediate effects. This is one central failure of the IMF package, as it tries to address a current crisis mainly by long term reforms which will take 5-10 years to have full effect.

2. Respite from Financial Market Pressures. In our view it is clear that, to address the immediate problems, Indonesia needs some temporary respite from the pressures of an open world financial system. Indonesia is one of many countries which have been pushed into this open world system without being fully prepared. It needs to retreat temporarily, returning to full open markets when it has a more robust financial system and better controls.

3. Continue Most Long Term Reforms. It seems equally clear that, if Indonesia is to return to stable long term growth, many of the reforms which have been pressed on it by the international community need to be implemented. However, those which are impacting adversely on resolution of the immediate problem should be delayed.

4. Regaining Control of National Affairs. Another principle is that Indonesia needs to regain control of its national affairs, a control that it has ceded to other parties as a result of the overhang of foreign currency debt. 5. Priority to Exports, Eliminating the Debt Overhang and Attracting Foreign Direct Investment. Our final principle is that, to recover quickly from the crisis, Indonesia needs to give priority to increasing exports on the basis of its increased competitiveness, to removing the debt hanging over both firms and the currency and to attracting direct foreign investment at a realistic exchange rate.

Our suggestion as to how Indonesian might proceed at this point has seven components, as outlined below.

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 reasonable outcomes for inflation and economic activity, to ensure a current account surplus for Indonesia. As a working premise we suggest something in the Rp 5,000 to 6,000 range, say 5,500. This rate would be supported by Indonesia's existing foreign exchange reserves, but not in the form of a Currency Board.

Effective policing of the limits of this fixed rate will not be easy. For this reason, consideration could be given to starting the fixed rate with a defined set of exports and imports, gradually working up to the inclusion of all current account and FDI transactions.

2. Restricted Capital Account Convertibility; Controls on Capital Flows. The government should, for a period of no longer than three years, re-introduce 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.

The same objective -- eliminating the influence of capital transactions on the currency value for trade and FDI -- could also be achieved by having a dual rate, and allowing the rate for capital transactions to float. While there are pros and cons, on balance we believe that capital controls may be more effective as part of a broader package.

3. Establish a Debt Reconstruction Agency to Eliminate the Foreign Currency Debt Overhang of Indonesian Firms. There are two polar ways in which this overhang can be eliminated reasonably quickly. One is for the Indonesian government to agree to convert the foreign currency debt to rupiah debt at an appropriate exchange rate (but one say 20 percent lower than the fixed exchange rate), and itself assuming the foreign currency debt while recovering the rupiah value from the local firm. The other is for the local debtor firm to renegotiate with the foreign creditor for rescheduled terms or part payment, or in the extreme become bankrupt and default on the debt.

In our view the Indonesian government should establish a Debt Reconstruction Agency to bring together firms, lenders and expert officials to resolve the debt position of companies as a matter of urgency. In these tripartite negotiations the option of the government, through the Agency, offering to convert the foreign currency debts of viable Indonesian firms to debts in rupiah should be available, although used sparingly. It 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.

In such a process it needs to be made very clear that firms which are not likely to be viable will be allowed to fail, and be subject to normal national and international debt recovery processes for bankrupt firms. Any rupiah recovered by international firms through such processes should be convertible at the fixed rate. International lenders whose creditors are unable to pay in part or whole should incur normal commercial losses.

The effectiveness of the Debt Reconstruction Agency will heavily depend on the transparency of its processes, and its independence from vested interests. It may be desirable to seek technical and other support from regional countries such as Australia and Singapore, to strengthen the arm of the Agency in negotiating with both Indonesian firms and international lenders.

4. Commitment to Long Term Reform. In spite of there no longer being the need for large scale IMF support, the government should commit to implement the IMF reform package as a matter of urgency, with the exception of those measures which are directly counterproductive to the immediate needs of the economy (the abolition of BULOG and of certain subsidies and monopolies, restrictive fiscal policy, high interest rates and the immediate opening up of the financial system).

5. Controlling Price Increases. Contrary to the IMF proposals, measures which contribute to rising prices, or perhaps more importantly to expectations of rising prices, should not be implemented at the present time. This includes the abolition of BULOG and the phasing out of subsidies on certain items. While in the long term the food distribution process needs to be substantially reformed, and subsidies reduced, the immediate priority must be to control the growth of inflation.

6. Expansionary Fiscal Policy. Again contrary to the IMF proposals, Indonesia's current need is for an expansionary fiscal policy, to assist the economy recover from the trauma of the last six months. This should be undertaken, however, in the context of a phased return to a balanced or surplus budget, consistent with Indonesia's long term stance of fiscal prudence.

7. Firm Monetary Policy Directed at Inflation. 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. 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. Control of inflation is vital to ensure the integrity of the fixed exchange rate, as well as to lay the foundations of renewed long term growth.

The aim of this proposal is 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. David Ray is an economist specializing on Indonesia at the Center, and has just completed a Ph.D thesis on innovation and growth in the Indonesian economy.