Suggestions to beat RI crisis

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.