The `blueprint' of Indonesia's postcrisis economy

The `blueprint' of Indonesia's postcrisis economy

Faisal Basri and Gatot Arya Putra, Jakarta

In Indonesia, the contribution of foreign direct investment
(FDI) to its gross domestic capital is still very low -- only 6.2
percent, according to a 1997 research. FDI's contribution to
large-scale industrial output was recorded at only about 25
percent in the 1990s, to its gross export earnings at 35 percent
and to its net manufacture export earnings at 20 percent.

FDI can also increase the foreign exchange outflow during a
crisis. In the absence of FDI at the start of the crisis, the net
FDI-related outflow of foreign exchange increased from US$360
million in 1998 to $2.75 billion in 1999, to $4.55 billion in
2000 and to $5.88 billion in 2001.

As the volatility of domestic consumption is also influenced
by portfolio investment, authorities need to improve supervision
of the capital market and reduce incentives for short-term
trading by, for example, imposing a higher tax rate on profits
earned through short-term trading.

Incentives should also be offered to institutional investors,
rather than to retail investors. Indonesia has been suffering
from capital outflow through the capital market during the
crisis. Capital outflow reached $13.49 billion in 1998, $7.18
billion in 1999, $5.44 billion in 2000 and $1.38 billion in 2001.

In employment, rigid regulations have caused continuous
declines in the competitiveness of our products. Even though the
unemployment rate did not increase during the crisis, workers
continued to enjoy a real wage increase -- meaning that their
wages increased at a higher rate than inflation -- except in
1998. Because the real increase of wages is not accompanied by
improvement in productivity, the competitiveness of the
Indonesian industry is actually in serious danger.

In the monetary sector, government policies, including that on
the slow growth of money in circulation, place too much emphasis
on reduction of demand. Continuous slow growth after the start of
the crisis has been caused partly by demand reduction policies.

Authorities should have responded to the weakening of the
aggregate demand -- as marked by the declines in investment -- by
introducing a policy on expanding money in circulation to support
economic growth.

The government's policy to continually curb inflation may
discourage new long-term investment, because the drastic decline
of the year-on-year inflation rate from 10 percent last December
to 7.1 percent in March, has increased real interest on banking
loans.

Government policy on propping up the rupiah's value against
major foreign currencies has caused the state budget to lose its
flexibility toward economic development. Such a policy was
imposed some years ago to meet the requirements set by the
International Monetary Fund (IMF), whose financial assistance was
strongly needed to end speculation on the rupiah.

Even though the IMF finally approved the implementation of
deficit financing and the allocation of social safety nets, the
introduction of such a policy was too late -- the budget's fine
-tuning function toward economic development had already
weakened.

The issuance of bonds by the government for the
recapitalization of banks has also reduced demand because it has
lowered banks' loan-to-loan deposit ratio (LDR) and driven the
government to intensify tax collection to repay bonds and pay
interest. The government's aim to balance its budget by 2005 may
also accelerate an increase in tax collection, which in turn
would affect businesses when banks are slow in expanding credits.

Meanwhile, the government may find difficulties servicing its
foreign and domestic debts. Its payment of foreign debt principal
is expected to increase from Rp 16.7 trillion in 2003 to Rp 46.4
trillion in 2004, and to Rp 48.9 trillion in 2005, before falling
slightly to Rp 47.9 trillion in 2006. Meanwhile, its payment of
foreign debt interest will increase from Rp 26.8 trillion to Rp
27.5 trillion, before declining to Rp 26.6 trillion and to Rp 26
trillion.

Because the debt obligations are so substantial, while the
IMF's assistance may end in the near future, the government
should consider very seriously whether it will be able to seek
the rescheduling of its foreign debt services without the help of
the IMF, and assess the efforts it has made to fulfill its debt
obligations.

Such a serious consideration is very important because,
besides the foreign debt services, the government also has to
service its domestic debt. Its payments of domestic bonds and
accrued interest are estimated at Rp 30.5 trillion and Rp 53
trillion respectively in 2004, at Rp 35 trillion and Rp 49.9
trillion in 2005, and at Rp 36.7 trillion and Rp 48.7 trillion in
2006.

In industry and trade, Indonesia has failed to create or to
sustain winning sectors based on comparative advantages. Our
competitiveness, according to research by the United Nations
Industrial Development Organization (UNIDO), has declined since
1993 -- four years before the crisis -- as is indicated by the
sharp decline in the annual growth of non-oil and non-gas exports
to about 7 percent in the following four years, from around 30
percent previously.

The policies recommended by the IMF also have not helped to
improve our comparative advantages, because the policies are
oriented toward demand reduction and liberal trade, which affect,
respectively, domestic sales and infant industries.

A strong domestic market is needed before the lifting of
import barriers. Thus, the IMF's recommendation for Indonesia to
expedite import barriers will only reduce the competitive
advantages of the domestic industry.

However, trade openness also offers positive impacts on
economic growth. Thus, the government needs to formulate
systematically coordinated policies to create conditions
conducive to investment and to increased efficiency in industry.

The government also needs to reduce direct involvement in
businesses by promoting privatization; but privatization should
be preceded by the creation of a healthy environment of
competition.

Another problem is that small and medium enterprises (SMEs)
generally find difficulties in expanding. Their major problems
include access to banking credits, technology and management
skills, training, marketing and subcontracting, apart from
difficulties arising from government regulations and available
locations.

To solve all these problems, we need a strong leadership for
the transformation of business cultures -- without having to bow
to temporary political interests -- in the restructuring of the
economy and at the same time, in narrowing the financing gap.

Policies should be neutral and incentives should be directed
toward the development of the nation's software, such as improved
governance, law enforcement and the protection of property rights
for the diffusion and innovation of technology. Further, the
introduction of autonomy should not hamper the inter-regional
movements of people and goods.

Faisal Basri teaches at the School of Economics of the
University of Indonesia. Gatot Arya Putra is a former head of the
planning division at IBRA, the Indonesian Bank Restructuring
Agency. The above is taken from the writers' presentation at The
Jakarta Post seminar on Strategy for Indonesia's Economic
Development held on April 28.