Sustaining economic growth in Indonesia

By Ali Wardhana

The following article is based on a paper presented at the conference on "Sustaining Economic Growth in Indonesia: A Framework for the 21st Century" held Dec. 17 by the United States Agency for International Development, the University of Indonesia's School of Economics and the American Committee on Asian Economic Studies.

JAKARTA: This conference takes place against the background of a severe financial crisis that has affected all East Asian economies, reaching from Thailand as far north as Korea and Japan. Over the coming years many opinions will be written on the origins of the crisis. Some of the papers at this conference and especially the discussions, both formal and informal, that follow will begin our search for answers.

It is critically important that we develop a full understanding of the economic events that led up to the crisis and that we look at policy measures that might have been taken to either prevent the economic storm or mitigate its impact. Of course economic downturns are nothing new. But the current crisis, if not thoroughly understood and analyzed, has the potential of eroding much of the global support for economic policies that have guided governments in developed and developing countries for over two decades -- a period of unprecedented economic expansion.

To begin, we should recognize that while the crisis is regional in origin, its impact will be global. Import demand in the affected economies will shrink, reducing exports from Europe, Japan and the United States. At the same time, the more competitive exchange rates that have now been established will result in an increased export drive from Asia. Where can such exports go? A large part of the exports from Southeast Asian economies have always been sold to Japan and Korea. But the economic growth rate forecasts for those two countries suggests that their import demand will be low for at least a year or two.

That leaves Europe and the United States, the two economic regions that are still growing at a relatively robust rate. However, the increasing flow of imports into those two regions has the potential of creating economic dislocations which may erode the political consensus that has pushed for more open markets for goods and capital.

We already see early warning signs that Europe and America may once again move to protect their domestic markets rather than lead the drive for more open global markets. If this happens, not only would the recovery in Asian countries be retarded, but world economic growth would slow with serious economic and political consequences.

What are the issues we need to understand if we are to answer the critics of global integration? Very briefly, I would focus on three broad issues.

First, while countries with more open markets apparently have higher rates of growth, critics of globalization have suggested that the benefits of increased trade have not helped the poor and have worsened income distribution. Yet a careful reading of the evidence does not support these views. For example, a recent study concluded that "there is a strong association between the rate of growth in average living standards and the rate at which absolute poverty has fallen" (Martin Ravallion and Shaohua Chen. "What Can New Survey Data Tell Us about Recent Changes in Distribution and Poverty?" The World Bank Review. Vol 11, No. 2, 1997).

Indonesia's experience bears this out. Our poverty rates have fallen, from 40.08 percent in 1976 to 11.39 percent in 1996. Some express disbelief in these results. They argue that there are many "near poor", defined as those whose income is just above the poverty line, and that a higher poverty line would not show such an improvement in the poverty situation.

Our poverty line, based primarily on a minimum food consumption level, is low but even if one adopted a higher poverty line the trend in poverty reduction would not change, although the number of people counted as poor would of course increase. If one were to raise the official poverty line by 10 percent, one would raise the number of people classified as poor in 1996 from the current official estimate of 11.3 percent of the population to 16 percent of the population (Frank Wiebe. "The Implications of Constructing a New Formulation of the Poverty Line." Unpublished paper April 1997).

But the basic conclusion that rapid export-led growth in Indonesia helped to raise a large number of our citizens out of absolute poverty remains.

The issue of whether rapid growth and integrated global markets worsen income distribution is less easily dealt with. Recent data suggests that inequality levels appear to be rising in a number of East Asian countries, with Malaysia the only exception (Vinod Ahuja, et al., "Everyone's Miracle? Revisiting Poverty Reduction and Inequality in East Asia." Unpublished world Bank paper , April 1997).

Inequality rose in China, Thailand and Hong Kong and it appears to have risen in the Philippines and Korea, although the changes are small enough to be within the margin of error of the measurement.

The same is true for measured income inequality in Indonesia where the Gini coefficient, derived from per capita household expenditure data, showed a decline from 0.35 in 1970 to 0.32 in 1990. Since then the Gini has risen to 0.34 in 1993 and to 0.36 in 1996, with the coefficient rising in both rural and urban areas, although the rise in rural areas was small ("Pengeluaran untuk Konsumsi Penduduk Indonesia: 1996. Survei Sosial Ekonomi Nasional." Biro Pusat Statistik, Jakarta, Indonesia, February 1997).

It is difficult to say what has caused this increase in inequality here and elsewhere or even whether it is a temporary phenomenon or the result of a longer term trend set in motion by the dynamics of economic reform. Before we can seriously debate the relationship between global integration and income distribution, we must look at this issue in depth, taking into account different economic structures and political regimes that characterize different countries.

Unless we can shed some light on this issue, opponents of global integration will continue to argue that the benefits of open markets and export-led growth disproportionately benefit the rich while the cost of adjustment falls disproportionately on the backs of the poor.

Second, there have been suggestions that government actions could have prevented the crisis or helped control its regional effects. We now know that one of the risks of global financial integration is the rapid spread of a financial crisis from one economic center to another. What might governments do to prevent the spread of financial panic?

One obvious answer is to pull back and impose capital controls. But the negative economic consequences of strict exchange controls and closed financial markets are well documented and do not need to be repeated here. Flat out capital controls are an invitation to corruption and inefficiency. Less extreme remedies, such as Tobin's call for a global transactions tax that would serve to throw sand in the wheels of super- efficient financial vehicles, have been proposed (Cf, Barry Eichengreen, James Tobin, and Charles Wyplosz. "Two Cases for Sand in the Wheels of International Finance." The Economic Journal, Vol. 105, January 1995).

All of the proposed remedies are "second best" solutions. They would make sense only if policy choices were so constrained that only the use of non-optimal measures could increase public welfare. The first question then is whether the constraints on policy choices are, in fact, real.

If so, we could argue that while a tax on capital inflows would reduce public welfare, a failure to ensure that rapid capital inflows are invested properly would also reduce welfare. We also must consider whether any proposed measure intended to control capital flows would restrain domestic speculators, who are also involved in currency dealings. And finally, we need to judge whether the restraints, if effective, would be desirable in a broader cost-benefit calculation.

Third, critics have suggested that exchange rate volatility erodes, and perhaps totally eliminates, the benefits from financial integration. It is reasonable to suggest that the volatility that has characterized international financial flows in the past will not go away any time soon. What role can the international community play in moderating this volatility and in mitigating the economic impact of rapid inflows and outflows of capital?

Part of the difficulties now facing Asian economies can be traced to the excessive flow of funds that were made available to these markets. Unfortunately such funds were often invested poorly. The same enthusiastic investors who poured their money into Asian economies rapidly withdrew their funds when economic weaknesses were exposed.

The rapid withdrawal of investment funds further damaged these economies. As a recently completed study concluded, market players must bear some of the blame for the financial crisis that has swept Asia (William R. Cline and Kevin J.S. Barnes. "Spreads and Risks in Emerging Market Lending." Institute of International Finance, Washington DC, November 1997).

What remedies might one seek? At the very least, better reporting on private capital flows would be useful. Even more, one would hope for data that would flag any dramatic decline in the risk-adjusted spread between yields on emerging market securities and the yield on some international bench mark securities.

Policy makers could then judge whether such a decline was justified by the underlying economic conditions or reflected unwarranted euphoria. Such information would allow governments to take steps to ensure that there was neither an unjustified level of capital inflow or a rapid outflow.

These are some of the questions that will be raised as the past experience with increased globalization and especially increased integration of financial markets is scrutinized. As economists and as policy analysts, we must be ready to provide answers.

Let me close with a prediction. Although the present economic forecasts for East Asian economies are gloomy, the crisis will pass and growth will resume. While there are numerous policy measures that must be implemented before this can happen, my optimism is based on the fact that all the affected Asian governments have begun the process of policy reform, either under their own initiative or with input from the International Monetary Fund and other multilateral agencies.

Let there be no doubt that the Asian miracle was real. The rapidly growing Asian economies did create a base of human and physical infrastructure and that base remains intact. It is on this base that we will eventually be able to resume our rapid growth.

Dr. Ali Wardhana is an economic advisor to the President, and a former finance minister and coordinating minister for economics, finance, industry and development supervision.