Indonesia and the IMF
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Indonesia: The Challenge of Sustaining the Economic RecoveryAnoop Singh
International Monetary Fund
University of Indonesia
50th Anniversary Conference
October 4, 2000
1. With a much more stable macroeconomic environment, strong international support for Indonesia’s economic reforms, and an ongoing recovery, market confidence should be high. However, this is not the case, and the question on everyone’s mind is how best Indonesia can sustain the recovery. I am glad to have this opportunity to focus on some of the key macroeconomic, financial, and other challenges that lie at the heart of this question.
2. Let me touch on three topics
I. Recovery from crisis
3. It is hardly necessary to recall the crisis conditions that prevailed in Indonesia just two years ago. By mid-1998, the exchange rate had collapsed, reaching a low of more than Rp 15,000 to the US dollar, compared with about Rp 2,500 before the crisis. Output was contracting sharply and, by the end of the year, had declined by about 13 percent—certainly the largest fall among the Asian crisis countries and, possibly, the largest single-year fall of any country in recent economic history. With rising food insecurity, the country was on the verge of hyperinflation. The banking system had virtually ceased to function and the corporate sector was weighed down by the recession, inflation, and its corporate debt. In short, Indonesia was in a vicious downward spiral.
4. Much of this now seems long ago and far away. Complacency may be the enemy of economic reform but it is also a measure of how much better shape the economy is in now. Let me quickly review the achievements of the past two years:
5. What explains these results? What stands out is the development and implementation of a sound macroeconomic framework, supported by successive measures to restore confidence in the banking system and rebuild key economic institutions, especially the following:
6. Let me now turn next to discuss the challenges that lie ahead. The most immediate of these challenges arise from the volatility in market sentiment that has been evident for much of this year. Restoring market confidence in Indonesia’s economic prospects is crucial to reviving the investment and capital flows that will be necessary to deliver sustained growth.
II. Market Confidence and fiscal sustainability
7. Despite the macroeconomic achievements to which I have just made reference, and the successful conduct of last year’s Parliamentary and Presidential elections, market confidence has been volatile in 2000. This volatility is beginning to affect the macroeconomic achievements. For example, inflation has begun to creep up. Although there was virtual price stability for much of the first half of this year, the 12 month inflation rate has now reached about 7 percent, largely a result of the more depreciated level of the rupiah. In an environment of already large risk premia, investors continue to adopt a wait and see attitude, and flight capital has still to return. Such an environment has already put renewed pressure on nominal interest rates and also makes it difficult for much delayed corporate restructuring to take place. There must be high priority given to reversing present sentiment.
8. There are many reasons for the decline in market sentiment. I do not want to go into all the possible reasons, and I am sure many of you here today will know more about the interplay of political developments and market confidence. Instead, I would like to focus on some of the major economic factors that are weighing down on market sentiment. One of these factors is, certainly, the slow progress Indonesia has made in asset recovery or restructuring, relative to the large size of the problem. Indeed, Indonesia’s relatively large debt burden makes it all the more imperative to make progress in asset recovery. Thus, concerns about fiscal sustainability may well dominate the economic factors that are weighing down market confidence. These concerns will remain—likely come into fuller exposure—when the other factors—those of a more political nature—have been addressed.
9. What do I mean by fiscal sustainability? It means that the government is in a position to repay its debts, both now and in the future, in an orderly way—without resorting to extraordinary measures. A simple measure of sustainability is a declining trend in the debt-to-GDP ratio. Such an outcome generally requires the rate of economic growth to exceed the real interest rate. Without this condition, the burden to run a fiscal surplus increases.
10. Markets worry about fiscal sustainability in Indonesia for a number of reasons. Among them are the following:
11. Given this background, it is very important for markets to be reassured about the government’s ability to meet its debt servicing burden in an orderly way. As long as investors doubt this ability, interest rates will have to remain high; this is the counterpart of the risk premium demanded by investors to compensate them for the higher perceived risks of holding the government debt. And, as we all know, higher interest rates impose a heavy burden on the economy. For one, they reinforce the weight of the debt on the budget, thereby forcing the government to seek offsetting savings elsewhere. Perhaps more important, they discourage new investment spending, thereby directly detracting from growth. There are many international examples of countries where concerns about fiscal sustainability kept interest rates well above the inflation rate, and contributed to low growth.
12. Therefore, it is imperative to prevent Indonesia from experiencing the same prospects. Now that the economy is stable, and a recovery underway, the next important step is for the government to take measures to reassure markets of its commitment to bringing down the debt burden over the medium term, thereby maintaining fiscal sustainability. I will now briefly discuss the elements in the government’s approach to support this objective.
III. The Strategy for Fiscal Sustainability and Growth
13. The importance of fiscal sustainability—of bringing down the debt burden in an orderly way—was well recognized by Parliament last year, when it enunciated the Guiding Principles for State Policy. The present economic program builds the framework to accomplish this reduction in the government’s indebtedness, and seeks to do so in an orderly way. The basic strategy relies on maintaining a favorable macroeconomic environment, making progress with fiscal consolidation, and driving asset recovery. All of these factors would have a mutually reinforcing effect on stimulating new productivity-enhancing investments and capital flows, reducing real interest rates, and raising growth, thereby satisfying the conditions for reducing the debt ratio. Setting in train—and entrenching—such a virtuous cycle is the fundamental aim of the economic program. If fully achieved, our projections point to the government debt ratio falling to about 67 percent by 2004.
14. It should be recognized at the outset that this is no easy task for at least three reasons:
Let me now go on to discuss in more detail the principal avenues available to the government to bring down the debt ratio in the next few years. Many of these avenues will tend to—indeed are necessary to—raise efficiency and factor productivity at the same time.First, adjustment in the government budget.
15. During the crisis, Indonesia’s budget balance moved into deficit because of the need to support domestic demand, cushion the output decline, and expand support for the poor. Now that recovery is underway, it is appropriate that the process of scaling back the fiscal deficit should begin. As I have already mentioned, this will not be an easy process. Many parts of the expenditure budget have already been squeezed, and there is still substantial need for infrastructure and social safety net support. That is why a strong political consensus will be needed on how best to pursue fiscal consolidation and to make the necessary choices:
Second, implement fiscal decentralization without adding to the budget deficit.
16. The government is currently preparing to implement fiscal decentralization in 2001. There is much international experience that is guiding the government in its efforts. The international experience clearly points to the risk that the general government deficit could rise following decentralization. If this were to happen, it would make it all the more difficult to bring about a reduction in Indonesia’s burden of government indebtedness.
17. For this reason, the government is taking a number of actions to preserve fiscal neutrality during the decentralization process. Perhaps the most important enabling condition is to ensure that expenditure functions are transferred to local authorities to match the revenues that they are receiving. If this is not done, an additional burden would be placed on the government budget, at a time when it can least afford it. In short, finance should follow function, and not the other way around.
18. The government is also considering other measures that would contain the macroeconomic risks of fiscal decentralization and ensure that the overall debt reduction strategy remains on track:
Third, pursue recovery from publicly held bank and nonbank assets
19. Asset recovery is of the highest priority in the economic program, and not only because of its considerable potential to help bring down the government’s debt. Of equal importance is the role that asset recovery can play in sustaining the recovery. As is well known, IBRA controls a very large amount of assets—whose book value has been measured to be close to one-half of annual GDP—and needs to be put back in the private sector where they would be more efficiently deployed. The longer the assets remain in the hands of the government, and despite the best intentions of IBRA, the assets are likely to deteriorate. The same with asset sale prices—waiting with asset sales for their prices to firm usually produces the opposite result. These are the clear lessons from every country that has been faced with this task, and they are also the emerging lessons from Indonesia’s own experience. In contrast, accelerating asset recovery would jump start the revival of foreign investment into Indonesia and raise factor productivity, both of which are crucial for sustaining growth, while also helping strengthen the rupiah closer to its fundamentals.
20. Overall, over the next few years, bank asset recovery and the proceeds of nonbank privatization could be as important as the adjustment in the budget deficit in their contribution to reducing the debt ratio. All the institutions concerned need to play their part—especially IBRA and the JITF where there is considerable need for coordination of function—as well as the government as owner of the state-owned enterprises.
Fourth, safeguard public resources from being used for additional bank recapitalization
21. The principal reason why Indonesia’s government debt has risen so much during the crisis is because of the need to recapitalize the banking system. Indeed, there were previous episodes of bank recapitalization at public expense in the 1990s. For this reason, it is critical to ensure that—once the present recapitalization is completed—the government does not need to lead another bank recapitalization in the future. However, such an assurance is still not at hand. The restructuring process for the recapitalized banks is still underway and needs to be carried to completion, and private capital more vigorously encouraged. The process entails the following priorities:
IV. Concluding Remarks
22. I have stressed today that a coordinated strategy to reduce the government debt is an essential part of the process of restoring market confidence and sustaining the emerging recovery. Of course, this is not the only part of the process, but it may well lie at the heart of it. The international community is fully committed to helping Indonesia meet the challenges that are involved in this task. Just recently, the IMF Executive Board completed the second review of Indonesia’s Fund supported economic program, and I speak on the eve of an important meeting of the Consultative Group for Indonesia. Our role—that is to say, of the international community—is to give technical assistance, policy advice, and financial support for the implementation of the economic program. The program itself, as repeatedly emphasized by Coordinating Minister Ramli, is very much that of the government. We are there to support it.
IMF EXTERNAL RELATIONS DEPARTMENT