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.