The good news and the major economic risks

Mark Baird, World Bank, Country Director for Indonesia, Jakarta

At the heart of the structural agenda is restoring the integrity and credibility of public institutions, especially in the civil service and justice sector. Problems of corruption, collusion and nepotism are now much more visible. But improvements in accountability have not kept pace.

This credibility gap between transparency and accountability generates much frustration. Some would like to go back to the good old days -- when you knew who to pay, with well defined costs and benefits. But this is inconsistent with the new democratic ideals, and incompatible with the demands of a more open and competitive global economy.

Indonesia will have to reform its public institutions -- to serve its people and to improve the investment climate.

I would highlight five items for the coming years:

o Improve tax and customs administration. The government needs to raise revenues to finance its budget, in a way that doesn't distort or deter investment decisions. The recent establishment of a large taxpayer office in Jakarta is a promising start.

o Develop balanced labor market policies. Private investors complain about the negative impact of recent sharp increases in minimum wages, generous severance packages for workers, and growing labor disputes. To some extent, these trends reflect the emerging power of labor within a more open and society.

The challenge will be to find ways to balance workers' rights and investor interests, while the institutions for arbitration and settlement of disputes are being developed. No one gains when factories shut down and investment moves to other countries.

o Avoid excesses of decentralization. It has not led to the breakdown in public services. But it has created added uncertainties and risks for private investors (in the mining sector, for example). New taxes and regulations are adding to the costs of business and, in some cases, restricting the free movement of goods around the country.

Local government demands for ownership and management control of enterprises are often at odds with national policies (and common sense). The central government has the authority to step in and nullify conflicting policies and illegal rulings by local governments. This authority should be exercised more forcefully.

o Push ahead with IBRA asset sales and privatization. These are important to finance the budget deficit and to put productive assets back into the private sector. Because of the crisis, Indonesia has one of the world's largest public sector. In some areas, this may be justified.

But there is no justification for keeping many manufacturing firms, banks, hotels and shops under public control. Progress on IBRA asset sales is encouraging. But privatization of state owned enterprises continues to be very slow. A return to the masterplan of several years ago could revitalize privatization.

o Improve the regulatory framework for investment. Substantial investment in infrastructure such as power and telecommunications will be needed over the next few years. However, the scope for public investment is limited.

Efforts to attract private investment paid too little attention to sound market structures and regulatory arrangements; many of these projects had to be shelved or renegotiated. This contributed to the drying up of investment flows. Progress on these policy and regulatory issues would help attract the private investment needed to support infrastructure development and stronger economic growth in the future.

With progress in these areas, macroeconomic stability and a credible start on institutional reforms, Indonesia can attract the investment needed to sustain growth rates of at least 5 percent to 6 percent per annum. This would be good to reduce debt, create jobs and lift people out of poverty more quickly.

But what if this doesn't happen? Will Indonesia continue to muddle through at 3 percent to 4 percent growth? This is possible, provided the macroeconomic situation stays under control. But this might not happen, as pressures to stimulate the economy build up before the election. I don't expect a blow-out in budget spending. But I do fear growing pressures for more trade protection and less privatization.

Such populist measures are likely to further erode investor confidence. Hence the importance of pushing the reform agenda, so that policies can be locked in and results achieved; before the political pressures become too great.

(Meanwhile) at the World Bank we have had to confront our own legacy problems, while trying to readjust to the rapidly changing and uncertain realities. Our new Country Assistance Strategy (CAS), released in early 2001, is based on the assumption that Indonesia will slowly recover, with macroeconomic stability but halting progress on economic reforms. But just because we were right, doesn't mean we're satisfied.

We have tried to keep the reform agenda before the government and the public, working closely with the IMF on budget and banking issues, while stressing on more basic structural and legal reforms. We have also continued to open up to public scrutiny. Much of our policy advice is on our website, along with the proceedings of the Consultative Group for Indonesia.

What we haven't done is provide a lot of financial assistance over this period. New commitments from the Bank have averaged only $310 million per annum over the past three years -- less than a quarter of the levels of the previous decade. More than one third of this new assistance has been on highly concessional IDA (International Development Association) terms, mostly used to finance social services and basic infrastructure for the poor.

This lending program is consistent with the base case program laid out in our CAS -- and Indonesia's capacity to service debt. We could do more, if there is more rapid progress on improving public resource management and developing a new poverty reduction strategy. Developments are encouraging. But the government will have to decide how much it wants to borrow -- taking into account debt levels, the cost of funds from alternative sources, and the need to maintain basic expenditures on social services and anti- poverty programs.

Our biggest challenge over the past three years has been corruption. Having learnt that we cannot isolate projects financed by the World Bank from systemic corruption, we have concentrated our anti-corruption efforts on working with the government to put in place better procurement and financial management systems.

However, we have also stepped up efforts to improve the design and supervision of our projects. Complaints about corruption are now investigated by experts from our Institutional Integrity Department in Washington. Firms proven to have participated in corrupt practices will be barred from future contracts financed by the World Bank.

We have also started to be more pro-active at looking for corruption in Bank-financed projects through our own supervision efforts. The results of the first review, on the Sulawesi Urban Development Project, are now available on our website. The sample of contracts was small, yet we found compelling evidence of collusion among bidders and inadequate project oversight.

Our Institutional Integrity Department has launched investigations and the government has indicated that it will ask us to cancel the balance of unused funds. We have also agreed to prepare a joint action plan to address these problems -- before we move ahead with any new lending in the urban sector.

The biggest challenge here will be decentralization. Past problems will be even more difficult to manage when working with more than 350 local governments. But by channeling our money to reform-minded local governments, we can help reinforce commitment to good economic policies, the proper use of public funds and poverty reduction.

Ultimately, this is how most aid money should be allocated. The central government has to use its general grants (DAU) to give every region the means to provide minimum public services -- which means reducing the large fiscal inequities in Indonesia.

But the center can use its special grants (DAK) in much the same performance-based way as aid should be allocated. In this way, we can help build a better environment for private investment, more responsive and accountable local governments, and more effective anti-poverty programs.

The above article is abridged from the writer's address to the Jakarta Foreign Correspondents Club on Aug. 27.